5 Questions
What is the maximum profit of a covered call?
The potential upside in the stock between the current price and the strike price
What kind of investor is covered call strategy ideal for?
Investors who believe the underlying price will not move much over the near term
What is the covered call transaction called?
Covering
What happens if the stock price falls below the strike price?
The option will expire worthless
What is the purpose of a covered call?
To generate an income stream
Study Notes
- A covered call is a financial transaction in which the investor selling call options owns an equivalent amount of the underlying security.
- To execute this, an investor who holds a long position in an asset then writes (sells) call options on that same asset to generate an income stream.
- The investor's long position in the asset is the cover because it means the seller can deliver the shares if the buyer of the call option chooses to exercise.
- Covered calls are often employed by those who intend to hold the underlying stock for a long time but do not expect an appreciable price increase in the near term.
- This strategy is ideal for investors who believe the underlying price will not move much over the near term.
- Covered calls are not useful for very bullish or very bearish investors.
- The maximum profit of a covered call is equivalent to the premium received for the options sold, plus the potential upside in the stock between the current price and the strike price.
- The option writer can earn a premium for writing a three-month call option, but the option will expire worthless if the stock price falls below the strike price.
- If TSJ shares rise above the strike price, the option is exercised and the writer is capped at the stock's upside of $27.75. If the price goes above $27.75, the writer would have been better off holding the stock.
Test your knowledge about the covered call strategy, a financial transaction where an investor sells call options on an underlying security while holding an equivalent amount of that security. Learn about the potential income stream, maximum profit, and suitability for different market conditions.
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