Definition
Covered Call: A covered call is an options strategy where an investor sells call options on an asset they already own, thereby generating income (from option premiums) while being prepared to deliver those shares if the option is exercised.
| Covered Call | Naked Call |
|---|---|
| The investor owns the underlying asset | The investor does not own the underlying asset |
| Generates income via premiums | Exposes the investor to unlimited potential losses |
| Lower risk | Higher risk |
| Ideal for neutral-to-bullish markets | Suitable for bullish outlooks only |
Example
Imagine you have 100 shares of Stock A, which you purchased for $50 each. You’re optimistic about the stock enabling you to sell a call option with a strike price of $55. If the stock price remains below $55, you keep your shares and the income from the option premium. If the stock price exceeds $55, you’re likely to sell your shares at that price, but still profit from the premium!
Related Terms
- Call Option: An agreement granting the buyer the right to purchase the underlying asset at a specified price before a specific date.
- Put Option: An agreement that gives the buyer the right to sell the underlying asset at a specified price before expiration.
Formula
Calculating the potential income from a covered call can be as simple as pie:
\[ \text{Total Potential Profit} = (\text{Sale Price} - \text{Purchase Price} + \text{Premium}) \]
Mermaids in Mermaids 🐉
graph TD;
A[Covered Call] -->|Sell Call Option| B[Premium]
A -->|Own Shares| C[Underlying Asset]
B --> D[Income]
C -->|If exercised| E[Delivery of Shares]
Humorous Citations
- “Selling covered calls is like entering the peach cobbler business: you can’t just have the peaches, you need the perfect crust — or in this case, the stocks!” 🍑
- “I once sold covered calls on my indoor plants… Let’s just say the only thing blooming was my desperation!” 🌱
Fun Facts
- Investment in Limbo: A covered call is like holding cash under your mattress while renting out your air foundation — sounds good until the mattress goes up in flames!
- Historically, the strategy first emerged to help farmers hedge against bad crop years; they sold their future harvest as options! 🌾
Frequently Asked Questions
Q: What happens if the stock price skyrockets?
A: You might miss out on potential huge gains on the upside if the stock price skyrockets. But hey, at least you’ll have the option premium!
Q: Is the covered call strategy suitable for all investors? A: Not really; it’s best for those who want a steady income and don’t expect wild stock price movements—ideal for conservative souls looking for a little extra cash!
Further Reading & Resources
- Investopedia - Covered Calls - A deep dive into covered calls.
- Books:
- “Options as a Strategic Investment” by Lawrence G. McMillan – A classic that explains various options strategies in detail.
Take An Income Break: Covered Call Quiz Time!
## A covered call involves:
- [x] Selling call options on an asset you already own
- [ ] Buying put options to protect against price increases
- [ ] Creating phantom trades to confuse your broker
- [ ] Investing in a lemonade stand
> **Explanation:** A covered call is specifically about selling call options while owning the asset.
## What is the primary goal of executing a covered call?
- [ ] To leverage your portfolio
- [x] To generate income via option premiums
- [ ] To annoy pesky brokers
- [ ] To sell your shares for a loss
> **Explanation:** The main goal of a covered call is to create income by selling option premiums.
## What happens if the underlying asset exceeds the strike price?
- [x] You may have to sell your shares
- [ ] You can claim a refund
- [ ] You run a victory lap at your brokerage
- [ ] You retire early and write a book
> **Explanation:** If the stock price exceeds the strike price, you would likely sell your shares at the call option's strike price.
## What type of market outlook is best for a covered call?
- [ ] Bullish and volatile
- [x] Neutral to slightly bullish
- [ ] Bearish and slow
- [ ] Totally unrelated to market conditions
> **Explanation:** Covered calls thrive in neutral to slightly bullish markets, providing income without excessive risk.
## If the market plunges and the stock price drops, what is the effect on your call option?
- [ ] It will still make you money
- [x] It becomes worthless
- [ ] It magically doubles in value
- [ ] It becomes an expensive border decoration
> **Explanation:** If the stock price drops sharply, the call option will likely become worthless.
## True or False: A covered call can result in unlimited risk.
- [ ] True
- [x] False
> **Explanation:** A covered call has limited risk because you own the underlying shares, balancing any potential losses in the underlying asset.
## What does “naked call” mean?
- [ ] A fashion faux pas at the investment party
- [ ] Selling calls without ownership of the underlying asset
- [x] An embarrassing situation at a shareholder meeting
- [ ] A call option with extra toppings
> **Explanation:** A naked call refers to selling call options without owning the underlying asset, exposing the seller to significant risk.
## Which person is most likely to use covered calls?
- [ ] A novice day trader seeking quick profits
- [x] A long-term investor looking for additional income
- [ ] A squirrel saving nuts for the winter
- [ ] Someone who loves complicated derivatives
> **Explanation:** Investors aiming for reliable income from long-held positions typically use covered calls.
## What is generated from selling covered calls?
- [ ] New emerging markets
- [x] Options premiums
- [ ] Annual board game night
- [ ] Unexpectedly large pizza deliveries
> **Explanation:** Selling covered calls generates income from options premiums, helping investors supplement their returns.
## What should investors expect when using a covered call strategy?
- [ ] Complex mathematics
- [ ] Frequent stock market parties
- [x] Modest gains and some potential share sales
- [ ] Magic powers and crystal balls
> **Explanation:** Investors should expect modest gains and potential stock sales while generating income as the primary goal.
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