What is an Example of a Covered Call?
Selling covered calls is a financial strategy where an investor who owns a stock agrees to sell someone else the right to buy that stock at a certain price (called the strike price) for a set period of time.
Let's start with a non-financial example to help explain the concept. Imagine you have a really nice bike that you don't use very often. You could lend it to someone else, but you don't want to just give it away. Instead, you agree to rent the bike to someone for a week, but only if they agree to buy it from you at the end of the week for a certain price.
In this example, the bike represents the stock, the rental agreement represents the covered call option, and the agreement to buy the bike at the end of the rental period for a certain price represents the strike price.
If the person who rents your bike decides they want to buy it from you at the end of the rental period, they can use the option to purchase it at the strike price. If the bike goes up in value during that time, they might be able to make a profit by buying it from you at the lower strike price and then selling it for more. However, if the bike doesn't go up in value or even goes down in value, you get to keep your bike and the money you made from the rental agreement.
Now, let's move on to a financial example. Imagine you own 100 shares of a company called XYZ, and the current price of each share is $50. You want to make some extra money from your investment, so you decide to sell a covered call option on your 100 shares with a strike price of $55 and an expiration date of one month from now.
Someone else buys the covered call option from you for $1 per share, which means they pay you a total of $100 (since there are 100 shares in your position). This gives the buyer the right, but not the obligation, to buy your 100 shares of XYZ at the strike price of $55 per share, but only if they exercise the option before the expiration date.
If the price of XYZ stays below $55 before the expiration date, the buyer won't exercise the option, and you get to keep your 100 shares of XYZ and the $100 you made from selling the option. If the price of XYZ goes above $55 before the expiration date and the buyer exercises the option, you sell your 100 shares of XYZ for $55 per share, which means you make a profit of $5 per share ($55 - $50), plus the $1 per share you made from selling the option.
Selling covered calls can be a useful strategy for investors who want to generate additional income from their stocks. However, it's important to understand the risks involved, as there is always the possibility that the stock price could fall below the strike price, resulting in a loss.
Selling covered calls can also limit the potential profit you can make if the stock price rises significantly. For example, if the price of XYZ rises to $60 per share before the expiration date, the buyer of the option will exercise their right to buy your 100 shares at the strike price of $55 per share. This means you make a profit of $5 per share ($55 - $50), but you miss out on the potential profit you could have made if you had held onto the stock and sold it for $60 per share.
There are different strategies you can use with covered calls, depending on your investment goals and risk tolerance. Some investors sell covered calls on stocks they own as a way to generate extra income from their portfolio. Others use covered calls as a way to limit potential losses on a stock position they're not as confident in.
It's important to do your research and understand the risks involved before using this strategy. Make sure you understand the potential outcomes of different scenarios and have a plan in place for managing your risk.
In summary, selling covered calls is a financial strategy where an investor who owns a stock agrees to sell someone else the right to buy that stock at a certain price for a set period of time. It can be a useful way to generate extra income from your portfolio, but it's important to understand the risks involved and have a plan in place for managing your risk.
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Vijay Kailash, CFA
Founder & Lead Instructor at OptionSellingSecrets.com
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