What is a covered call?

Definition of ‘Covered Call’

An options strategy whereby an investor holds a long position in an asset and writes (sells) call options on that same asset in an attempt to generate increased income from the asset. This is often employed when an investor has a short-term neutral view on the asset and for this reason hold the asset long and simultaneously have a short position via the option to generate income from the option premium.

For example, let’s say that you own shares of the TSJ Sports Conglomerate and like its long-term prospects as well as its share price but feel in the shorter term the stock will likely trade relatively flat, perhaps within a few dollars of its current price of, say, $25. If you sell a call option on TSJ for $26, you earn the premium from the option sale but cap your upside. One of three scenarios is going to play out:

a) TSJ shares trade flat (below the $26 strike price) – the option will expire worthless and you keep the premium from the option. In this case, by using the buy-write strategy you have successfully outperformed the stock. 

b) TSJ shares fall – the option expires worthless, you keep the premium, and again you outperform the stock. 

c) TSJ shares rise above $26 – the option is exercised, and your upside is capped at $26, plus the option premium. In this case, if the stock price goes higher than $26, plus the premium, your buy-write strategy has underperformed the TSJ shares.

Via Investopedia.

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