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A Covered Call is an option strategy for investors who are in possession of the underlying shares or corresponding underlying assets. “Covered” means that the call option is “covered”, because if the option is exercised, the seller of the call already has the shares in his portfolio and does not have to purchase them first in order to hand them over to the buyer of the call. It is therefore possible to generate passive income with covered calls.
When is the sale of Covered Calls worthwhile?
It is worthwhile for the share owner to write covered calls (covered call writing) if stagnating or falling share prices are expected. If the share price falls, he will keep the shares because the buyer does not exercise the option, because it would be a loss-making transaction.
The sale of the options themselves does not result in any additional risk for the seller. The existing risk only arises from the ownership of the shares themselves and is already present before the option contract is entered into.
If the share price falls or stagnates, the seller of the put option will keep the shares in the portfolio, but can reduce the loss in value by the option premium received.
If the share was bought nicely a long time ago and has already risen considerably in value before the option was sold. The salesman of the option makes in then altogether only a somewhat smaller profit.
If the share price stagnates, the seller of the covered call option can make an additional (small) return through the option premium received.
Example: Stagnating and falling stock prices during the option term:
One share is quoted at € 95 at the time of the sale of the covered call. The seller of the covered call agrees a strike (exercise price) of €98 with the buyer of the option and agrees an option price per share of €2.00. Based on 100 shares, the seller receives an option premium of €200.
If the share price does not rise above €99.5, it makes no sense for the buyer of the option to exercise the call option because he would make an additional loss. For the buyer a loss in the amount of the 200 € paid for the option price, related to 100 shares, arises.
For the seller of the covered call option, the following picture emerges: First of all, he has collected 200 € option premium. If the share price stagnates around € 95 up to a maximum of € 98, he has made an additional profit, roughly in the amount of the option premium received.
If, on the other hand, the share price falls below € 95, he suffers a price loss from the shares. However, he would have to complain about this anyway. It can count itself however the collected option premium against it.
The price loss must not be realized however at this time. The investor can finally remain in possession of the shares and hope for a later increase of the share price.
Passive income through a covered call strategy
The fact that new covered calls can be acquired regularly makes it possible to generate passive income with comparatively low risk. Investors should focus primarily on undervalued companies that offer a relatively large safety margin at their fair value. This is also known as value investing. To put it simply, undervalued companies that are financially sound and sell marketable products are very likely to approach their actual value at some point. Companies with undervalued shares are also generally considered to be crisis-proof and carry a lower risk of insolvency.
There are now even ETFs that use a covered call strategy to generate a low-risk monthly return for investors.
Rising prices after the sale of the covered call
If, on the other hand, the share price rises and the option is exercised by the buyer, the situation is as follows: The seller can only realise a lower sales price overall than planned for the shares.
However, the difference between the market value and the selling price is reduced by the option received. Overall, however, the seller does not lose anything if the share was previously purchased “cheaply”.
The seller can only not further participate in the interim increase in value. An actual loss would only occur if the share was previously purchased at a very high price. For this to happen, the share price would have to have fallen considerably when the covered call was sold.
Example rising share prices during the option term:
Again, it is assumed that at the time of the sale of the Covered Call there is a price of € 95. A strike of 98 € is agreed. An option premium of € 150 is collected for this. The value refers to 100 shares.
If the share price now rises above €99.5 during the option term, the buyer of the call will exercise his option. The seller must therefore deliver the shares.
The situation of the seller of the covered call is as follows. The seller of the option must deliver the shares at a price of €95 per share.
As long as he had not previously purchased the shares at a significantly higher price than 95 €, he will not make a loss. He will then receive € 9,500 for 100 shares, plus € 200 option premium. In the overall account he will thus even make a small profit.
Disadvantage: He can no longer profit from the interim rise in the share price. However, this is only a “virtual” loss, which is not reflected in the option seller’s wallet.
Alternative: Rolling the covered call or closing the position
Let us assume that the seller of the covered call believes that the share price will move up after the option is sold. Although he has speculated on falling or stagnating prices, he could, for example, “roll” the option and thus counteract his risk.
This shifts the end of the term backwards. This is particularly interesting if the seller is of the opinion that the share price will nevertheless fall below the strike again later.
In addition, the position can be closed out alternatively by buying an opposite call. However, the option price to be paid in this way is offset against the previously received option price.
Read my other articles about options:
- Bear Call Spread Options Strategy
- Bull Put Spread – Earn Money With Puts And Limit Risk
- Butterfly Spread Options Strategy
- Definition Of Option Price/Option Premium
- Earn Money With A Covered Call Options Strategy
- How to exercise Options
- How to use the Standard Deviation for Options Trading
- Iron Condor – Profit From Low Price Fluctuations
- Options Trading Tutorial for beginners
- Options vs. Futures – Two Different Types Of Futures Contracts
- Options vs. Warrants – 4 Differences
- Protective Put – Hedging Of Equity Positions
- Simple Trading Strategies for Options
- Term structure options
- What are options? – Explained Simply And Quickly
- What is a Long Call in Options Trading?
- What is a Long Put in Options Trading?
- What is a Short Call in options Trading?
- What is a Short Put in Options Trading?
- What is delta in Options Trading? – The Most Important Key Figure
- What is Historical Volatility in Options Trading?
- What is the Gamma in Options Trading?
- What is the Implied Volatility Of Options – Important Or Not?
- What is the Theta in Options Trading?
- What Is The Vega Of An Option?