What is Covered Call?

The Covered Call strategy is an investment approach where an investor sells corresponding call options while holding the underlying stock. In simple terms, it involves selling call options to generate additional income while owning the stock. This strategy is suitable for investors who have a long-term bullish outlook on a stock but expect minimal short-term price fluctuations in the market.

The profit from the Covered Call strategy mainly comes from the premium received from selling call options and the capital gains from any increase in the stock price. However, the maximum profit potential is limited because once the stock price exceeds the strike price, the option may be exercised, preventing the investor from benefiting from any further appreciation in the stock price. Nevertheless, holding the stock as collateral means that losses are limited, although investors still face the risk of a decline in the stock price.

Case Analysis

For example, suppose you hold 100 shares of Company A, with a purchase price of $50 per share, totaling $5,000. You could choose to sell 1 call option simultaneously, receiving a premium of $5 per share, amounting to a total of $500. In this scenario, if the stock price rises to $55, you would need to sell 100 shares at that price, resulting in a maximum profit of $1,000. However, if the stock price falls below $45, you can still keep the premium but will have to face the losses associated with the decline in stock price.

Practical Applications

The Covered Call strategy can help investors achieve multiple objectives. First, by selling call options, investors can earn additional "rental" income while holding the stock. Second, investors can set a target exit price as the strike price for selling call options, allowing them to earn extra premium income. Lastly, selling call options can also reduce the overall cost basis of the stock, helping investors hedge against risks and mitigate losses from price declines.

In summary, the Covered Call strategy is suitable for long-term investors who want to generate extra income by selling call options while managing risk. When employing this strategy, investors should make informed decisions based on market conditions and their own risk tolerance.