Understanding the Covered Call

When you’re new to investing, just learning the concepts and terminology can be overwhelming. There are so many different strategies and approaches for analyzing stocks and whether you should buy or sell.

Sometimes, the best thing to do is break down key terms and learn them individually. One that’s definitely worth knowing is the covered call. This is an investment strategy that’s seen as ideal for conservative investors, and it’s used by professional investors as well.

The following are some of the primary things to know about the covered call.

What Is A Covered Call?

When you own a stock, you have the right to sell it anytime you choose for the market price. With covered call writing, you are selling the right to sell that stock to someone else while receiving cash paid today.

To simplify this further, this means you would give the buyer of your shares of the stock the opportunity of having the right to buy your shares before the option expires. It’s done at a strike price, which is predetermined.

Understanding the Strike Price

The strike price is a term that refers to the price at which a derivative contract can be utilized. Strike price is often used to refer to stock and index options where the strike price is a preset part o the contract.

With call options, the strike price indicates where the security can be purchased. For put options, on the other hand, the strike price is the price where shares can be sold.

The strike price of a derivative may also be referred to as an exercise price, and they’re outlined when a contract is initially written. What a strike price tells the investor is what price the underlying asset has to reach before the option is considered in-the-money.

So what’s the difference between the market price of a security and the strike price? The difference is represented as the profitability per share that’s realized with the option’s exercise or sale.

When an option is valuable this is referred to as “in-the-money.” If an option is considered worthless, it’s considered “out-of-the-money.”

When Is This Used

As mentioned, the covered call is often referred to as a conservative strategy, and it’s frequently used when the investor wants to generate income from a long position, within the framework of a sideways-moving market.

When someone utilizes a covered call, that investor then can carry on with their buy-and-hold strategy, and also make money from a stock that’s inactive at the given moment. However, for it to work, the investor or writer must assume and be correct in their assumption that the stock won't make gains within the option time frame.

It should also be noted that while the covered call offers a lower level of risk, the reward is also lower in most cases. It should also be pointed out that this strategy can carry with it large loss potential if the underlying security’s price is to fall, but the risk isn’t any different from any other type of stockholder risk.

Author:.

Carmelo is a marketing writer and blogger helping small and medium size businesses craft winning content strategies. She's always scouting the web for new social media strategies and is slightly addicted to apps. When not tapping the keyboard, you are likely to find her in the park playing with her uncontrollably friendly Irish setter or trying out new vegan recipes.

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