Covered Call – a transaction in which the seller of call options owns the corresponding amount of the underlying asset, such as shares of a stock or other securities. The long position in the underlying asset is the “cover” as the shares can be delivered to the buyer of the call if the buyer decides to exercise and thus they “cover” the obligation.
The owner of shares of XYZ stock, which is trading at $50, likes the long-term prospects as well as its share price but feels in the shorter term the stock will likely trade relatively flat. If the owner sells a call option on XYZ with a strike price $53 for $1.50 a share, you earn the premium from the option sale but the owner has limited his upside. One of three scenarios is going to play out:
- The share price of XYZ shares do not reach the $53 strike price and the option will expire worthless. The owner keeps the premium from the option. In this case, by using the buy-write strategy you have successfully outperformed the stock.
- XYZ shares lose value and end below $53 and the option expires worthless. The owner keeps the premium from the option. In this case, by using the buy-write strategy you have successfully outperformed the stock.
- XYZ shares rise above $53 and the option is exercised. The owner’s upside is capped at $53, plus the option premium. In this case, if the stock price goes higher than $53, plus the premium, your buy-write strategy has underperformed the XYZ shares.
