Definition
The term covered call refers to a strategy in which the seller of a call option owns all of the underlying securities outlined in the contract. Investors will do this when they do not believe the asset will increase in value over time, and would like to profit from the option premium.
Explanation
Also known as "buy-write," a covered call involves a transaction whereby the writer of the call agrees to sell a fixed number of securities at a specified price, and within a given timeframe to another party. Call options typically involve securities such as stocks and bonds, as well as commodities.
The seller of a call option is referred to as the writer, who is obligated to sell the securities to the holder of the call option if they exercise their right. The buyer of a call pays a fee, known as a premium, to own the right to exercise their option. If the seller of a call owns a corresponding amount of the underlying security, the option is said to be "covered," which means the seller does not have to purchase shares on the open market if the buyer of the call decides to exercise their option.
Generally, the buyer of a call option is bullish on the security, since they believe its price will increase over time. The writer of the option has a bearish or neutral view in the case of a covered call. There are three possible outcomes when writing a covered call:
Flat Price: the underlying security's value does not rise or fall over the term of the option, and the buyer of the call does not exercise their right to buy the securities. When this happens, the writer of the covered call profits from the premium they received.
Declining Price: the underlying security's value falls over the term of the option, and the buyer of the call does not exercise their right to buy the securities. When this happens, the writer of the covered call profits from the premium they received. However, since they own the underlying securities, they own an asset that is less valuable.
Increasing Price: the underlying security's value increases over the term of the option, and the holder of the call exercises their right to buy the securities. When this happens, the writer of the covered call profits from the premium they received. Since they own the underlying securities, they also realized a profit on the sale of their securities. However, the profit they realize is capped at the strike price.
Related Terms
The term call option refers to a financial contract that gives the investor the right to purchase a security at a specified price before the agreement expires. A call option is not an obligation to purchase the security; it merely provides the holder with the right to purchase it.
Moneyzine EditorJanuary 10th, 2024- The term naked call refers to a strategy in which the seller of a call option does not own the underlying securities outlined in the contract. Naked calls are considered an advanced options strategy, since it carries unlimited risk.Moneyzine EditorSeptember 20th, 2023
- The term naked put refers to a strategy in which the writer of a put option does not own the underlying securities outlined in the contract. Naked puts are considered an advanced options strategy, since they carry considerable risk, which is only second to naked calls.Moneyzine EditorSeptember 20th, 2023
- The term put option refers to a financial contract that gives the investor the right to sell a security at a specified price before the agreement expires. A put option is not an obligation to sell the security; it merely provides the holder with the right to sell it.Moneyzine EditorSeptember 21st, 2023
