Covered Call in simple words can be defined as selling rights of a stock to someone else, in exchange for a certain amount that the buyer pays to the stock owner. Moreover, Covered call is a process which might allow the owner of the stock to earn additional profit.
However to understand covered call we must go through some of its basic terminologies.
1. Call Option
2. Strike Price
3. Expiry Date
1) Call Option:
Call Option is a contract between a buyer and a seller. In this contract the buyer purchases the right to buy the stock at a defined price and at also at a particular date. On the other side the seller is liable to give out the stock at a certain price and also at a specific date. It can be compared with an insurance policy. The higher the risk, the higher the amount of premium is charged over the Insurer. For example, Bill bought 100 shares of a ABC Company, but was not satisfied by the performance of the company hence he decided to put a call option. This way, he was able to sell out his share and lower the risk of his personal damage or loss.
2) Strike Price:
Assuming that one has bought a call option, the price that the buyer will pay is be known as strike price; same way, strike price for the seller will be the price at which s/he is intending to sell the stock. Strike Price is more than the current price. For example, current price of company’s share is 30 dollars and the call option placed by the seller is for 50 dollars. This fifty dollar is the strike price.
3) Expiry date
It is the date at which the call option is no longer worth of being fulfilled. For example, the buyer and the seller of the call option committed to use the call option within six months but due to lack of enthusiasm of the buyer. The call option was brought to action. Hence the seller profit out of premium even after the expiry date.
The extra amount one pays when he or she buys any call options by the seller’s point of view. The amount that will be received over a call option is known as premium. By the point of view of the buyer the extra amount paid over the call option is known as premium. For example, Mr. Adam bought a call option for thirty dollars for XYZ Company, where the current price of their companies share is twenty five dollars thus the five dollars is the premium paid by Mr. Adam.
Guidance of Covered Call
Many investor sell call option to earn more profit out of the stock that they already own. In this process the investor hires a call option, the price of the call option is more than the current price of the stock. This is known as the strike price. They usually do it when they assume that the price of the stock will no longer rise, so if the price does not rise over call option the investor earns the premium. However, if the price does rise over the call option the investor will suffer a loss. Assuming that if the price of the stock goes way beyond the strike price then the investor will vying a massive loss.
EARNING PROFIT FROM COVERED CALL
• Profit for the Call Option Buyer
The buyer will earn profit if the price of the stock rises over the strike price. This way he or she will get the stock at a cheaper price than the current price of the company and will also recover the amount of premium that was paid. For example, a person ‘A’ bought a call option for the price twenty eight dollars where the original price of the companies share is twenty dollars. If the price of the share rises to thirty dollars then person ‘A’ may use the call option and get the share for twenty eight dollars.
• Profit for the Call Option Seller
The seller will earn profit if the price of the stock declines or does not rise over the strike price then the seller will earn the amount of premium. For example, Mr. ‘B’ owns 100 shares of XYZ Company, he believes that the price of the share will not rise anymore so he determines to put out a call option for sixty dollars where the original price is fifty dollars. He will earn profit by the ten dollar premium that he is charging.
Benefits of Covered Call
• Covered calls can increase your turn overs extraordinarily. By knowing when to sell a call price, we can increase the value of our stock rapidly.
• We have the privilege of earning from a share that’s been neglected and its price is not rising the way it was expected.
• By using the covered call strategy our earning power increases highly because we have the advantage of repeating this procedure over and over again.
• The premium that the seller earns from opening the position lower the risk of the loss at the expiry date.
• Covered call lowers the cost of buying shares.
• The fluctuation of stock will avail by the general public which will increase the flow of cash throughout a country. This way the government will also generate taxes.
• Seller of call option is well aware of the position of the market thus he takes the advantage of time decay and make profit out of premium that he earns.
• It also provides the sellers peace of mind that in both ways he will get the advantage. For example, if the price rises over strike price even then the premium covers his loss.
• It is a low risk strategy with high rate of return.