Covered Calls in options trading

Covered Calls as a Hedging and Income Strategy

Are you excited about the long-term prospects of a security, but worried that its price might stay the same or fall in the short-term?

If so, you may want to consider selling a covered call. Selling a covered call obligates you to sell your stock at a predetermined price (strike price) in return for a premium you receive. Regardless of the option’s expiration date, you keep the option premium if the underlying security’s price moves up, down or sideways.

While the covered call option strategy may help generate income it does not provide full downside protection and may limit profit potential.  If the security’s price rises, you could be stuck selling your security at a price that’s lower than the market price. Why would you want to limit your potential upside? Maybe you feel that you have an opportunity to generate income from the premium and you are comfortable selling your stock at the option's strike price. Or you believe that in the short-term, the security will either fall or remain flat.

The highest payout on a covered call likely occurs when the option is called away, meaning you end up selling your security at the strike price. In that case, you keep the premium plus any price appreciation up to the strike price on the security.

Example of a Covered Call

You own stock in Company A which you purchased at $50. The shares are currently trading at $70. You think the price will remain relatively stagnant in the near term. Therefore, you sell a call option for a $2 premium on the security with a strike price of $71. If the stock reaches or exceeds that price, you may be obligated to sell at the strike price of $71. In addition, you will be able to keep the premium as well as the price appreciation up to the strike price.

Let’s say the stock price falls to $69 a share and stays there through expiration. In that case, the option expires as worthless and you get to keep the premium.

Risk: The primary risk of a covered call is limited upside. Let’s say that the stock of Company A rises to $80, and the buyer on the other side of the trade exercises the option. You would have to sell the stock at $71 a share,  which is less than the market value at the time.

Read Next: Using Cash-Secured Puts to Help Generate Income

The content provided is for informational and/or educational purposes only. The information presented or discussed is not, and should not be considered, a recommendation or an offer of, or solicitation of an offer by, Scottrade or its affiliates to buy, sell or hold any security or other financial product, or an endorsement or affirmation of any specific investment strategy. You are fully responsible for your investment decisions. Your choice to engage in a particular investment or investment strategy should be based solely on your own research and evaluation of the risks involved, your financial circumstances, and your investment objectives. Scottrade, Inc. and its affiliates are not offering or providing, and will not offer or provide, any advice, opinion or recommendation of the suitability, value or profitability of any particular investment or investment strategy.

Options involve risk and are not suitable for all investors. Detailed information on our policies and the risks associated with options can be found in the Scottrade Options Application and Agreement, Brokerage Account Agreement, by downloading the Characteristics and Risks of Standardized Options and Supplements (PDF) from The Options Clearing Corporation, or by requesting a copy from your local branch office. Supporting documentation for any claims will be supplied upon request. Consult with your tax advisor for information on how taxes may affect the outcome of these strategies. Keep in mind, profit will be reduced or loss worsened, as applicable, by the deduction of commissions and fees. The covered call option strategy may help generate income and offer limited downside protection, but does not provide full downside protection and may limit profit potential.

Scottrade, Inc. – Member FINRA /SIPC.

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