The Covered Call strategy is a popular and relatively conservative trading technique used by investors to generate additional income from their stock holdings. By selling Call Options on stocks they already own, traders can earn premiums while providing a cushion against minor price declines. Here’s a detailed look at how to effectively use the Covered Call strategy.
A Covered Call involves two main components: owning the underlying stock and selling a Call Option on that stock. The Call Option gives the buyer the right, but not the obligation, to purchase the stock at a specified price (the strike price) within a certain timeframe. In return for selling this right, the seller (the one who owns the stock) receives a premium.
The first step in implementing this strategy is to select a suitable stock. Ideally, choose one that you are willing to hold for the longer term and that exhibits stable price movements. Volatile stocks can pose higher risks, as sharp price increases could lead to the stock being called away, while sharp declines may not be sufficiently cushioned by the premium received.
Next, determine the strike price and expiration date for the Call Option. Typically, the strike price should be slightly above the current trading price of the stock. This way, you benefit from potential price appreciation up to the strike price, in addition to the premium. The expiration date can vary, but many traders prefer short-term options (one to three months) to maximise premium income and allow for frequent reassessment of market conditions.
With the stock owned and the Call Option parameters selected, the next step is to sell the Call Option. Upon selling, you immediately receive the premium, which can be seen as additional income or a slight buffer against potential declines in the stock price.
Once the Covered Call is in place, it’s crucial to monitor the position regularly. If the stock price rises significantly and approaches the strike price, be prepared for the possibility that the stock might be called away (sold) at the strike price. This isn’t necessarily a negative outcome, as you would have locked in a profit up to the strike price plus the premium received. However, if you wish to retain the stock, you might consider buying back the Call Option, potentially at a higher price.
If the Call Option is nearing expiration and the stock price remains below the strike price, you can “roll” the option. This involves buying back the expiring call and selling a new call with a later expiration date and possibly a different strike price. Rolling allows for continuous income generation from the same stock holding.
The primary benefit of a Covered Call strategy is the additional income generated from the premiums. This can enhance overall returns, especially in a sideways or mildly bullish market. However, the trade-off is that your potential upside is capped at the strike price, and you still bear the full downside risk of holding the stock.
The Covered Call strategy is an effective way to generate extra income from your stock portfolio while providing some downside protection. By carefully selecting stocks, strike prices, and expiration dates, and actively managing the positions, investors can make Covered Calls a valuable component of their trading toolkit.
If you’re interested in learning how to use this strategy and many more, feel free to call (03) 8080 5788 and speak with one of our Advisors, or you can check out our education programs by clicking here.