Covered call option explained
The long position in the underlying instrument is said to provide the "cover" as the shares can be delivered to the buyer of the call if the buyer decides to exercise. And if the stock price remains stable or increases, then the writer will be able to keep this income as a profit, even though the profit may have been higher if no call were written. The risk of stock ownership is not eliminated. If the stock price declines, then the net position will likely lose money.
Since in equilibrium the payoffs on the covered call position is the same as a short put position, the price or premium should be the same as the premium of the short put or naked put. Losses cannot be prevented, but merely reduced in a covered call position. If the stock price drops, it will not make sense for the option buyer "B" to exercise the option at the higher strike price since the stock can now be purchased cheaper at the market price, and A, the seller writer , will keep the money paid on the premium of the option.
This "protection" has its potential disadvantage if the price of the stock increases. If, before expiration, the spot price does not reach the strike price, the investor might repeat the same process again if he believes that stock will either fall or be neutral. A call option can be sold even if the option writer "A" does not initially own the underlying stock, but is buying the stock at the same time.
This is called a "buy write". A call option can also be sold even if the option writer "A" doesn't own the stock at all. This is called a "naked call". It is more dangerous, as the option writer can later be forced to buy the stock at the then-current market price, then sell it immediately to the option owner at the low strike price if the naked option is ever exercised. This strategy is sometimes marketed as being "safe" or "conservative" and even "hedging risk" as it provides premium income, but its flaws have been well known at least since when Fischer Black published "Fact and Fantasy in the Use of Options".
According to Reilly and Brown,: As a general rule of thumb, you may wish to consider running this strategy approximately days from expiration to take advantage of accelerating time decay as expiration approaches. Of course, this depends on the underlying stock and market conditions such as implied volatility.
Beware of receiving too much time value. Check for news in the marketplace that may affect the price of the stock. Remember, if something seems too good to be true, it usually is. Covered calls can be executed by investors at any level. The sweet spot for this strategy depends on your objective.
If you are selling covered calls to earn income on your stock, then you want the stock to remain as close to the strike price as possible without going above it. If you want to sell the stock while making additional profit by selling the calls, then you want the stock to rise above the strike price and stay there at expiration. That way, the calls will be assigned. You still made out all right on the stock.
Do yourself a favor and stop getting quotes on it. When the call is first sold, potential profit is limited to the strike price minus the current stock price plus the premium received for selling the call. You receive a premium for selling the option, but most downside risk comes from owning the stock, which may potentially lose its value. For this strategy, time decay is your friend. You want the price of the option you sold to approach zero.
That means if you choose to close your position prior to expiration, it will be less expensive to buy it back. After the strategy is established, you want implied volatility to decrease. That will decrease the price of the option you sold, so if you choose to close your position prior to expiration it will be less expensive to do so.
Options involve risk and are not suitable for all investors. For more information, please review the Characteristics and Risks of Standardized Options brochure before you begin trading options. Options investors may lose the entire amount of their investment in a relatively short period of time. Multiple leg options strategies involve additional risks , and may result in complex tax treatments. Please consult a tax professional prior to implementing these strategies.