Covered calls are quite similar to regular calls. They’re simply a variation of standard calls. Thusly, if you understand calls, you’ll have no trouble understanding a covered call option.
We’ll introduce covered calls in this article by explaining what they are. A covered call option is simply one type of option. Options are contracts that two parties enter into. They pertain to a particular underlying asset and its exchange. It can seem theoretical at first, but options conceptually are not too challenging to wrap your head around. Observe below an illustrative example to make sense of it all.
Say you purchase a call option. If you did, you would be purchasing the privilege but not the legal obligation, to buy the underlying asset at the predetermined strike price, at any point before the pre-determined “expiration date.” In this way, you may be able to buy the underlying asset for less than its market value. How is this so? If the market value is higher than the strike price, and you have the legal privilege to purchase the asset at the strike price, then you can secure a discount on the asset.
The following example should clarify this. Say you purchase a covered call from your broker. The underlying asset in this situation: 500 shares of Intel with a strike of $50/share. The expiration date is set for the 3rd Saturday in February with a premium fee of $200. How do all these specifics and numbers factor into the call option? Well you would pay the $200 premium to buy the option. Now if at any time before the 3rd Saturday in February you want to buy the asset at the strike price, you can do so by “exercising” the option.
If you choose to exercise, you receive the asset at the strike price of $50/share (you have to buy all 500 of them.) Like mentioned before, this can be lucrative should the market value of Intel increase beyond the strike price. You could also choose to sell the option instead, as the price of the option would increase with an increase in the price of the stock.
If Intel should stay the same or go down, you would not choose to exercise the option. You could sell the option while it still had some time value left or you could just take the loss of and be on your way, allowing the option to expire worthless.
At this point it’s important to explain the difference between a call option, explained above, and a covered call option. With a standard call, the writer of the option may not have the asset on hand. If the option is exercised, however, they will be required to purchase it to sell it to the buyer at the strike price. With a covered call, the seller of the option already owns the asset. This way, they are “covered” or protected by their ownership of the asset. The loss will not be as severe and dramatic for someone who already owns the asset. That’s how a covered call option works.
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