A covered call is an options strategy where the investor holds a long position in an underlying asset and writes (sells) call options on that asset to generate income from the premiums.
The covered call is one of the most popular options strategies because it enables the trader to earn income from their existing long position while still providing some upside protection in case the price of the underlying asset increases.
When writing a covered call, you are selling someone else the right to buy your shares at a set price (the strike price) for a certain period (until the expiration date). In exchange for selling this call option, you receive a premium from the buyer.
If the underlying asset’s price remains relatively unchanged or decreases, you will keep the premium as a profit. However, if the underlying asset price increases above the strike price, you may be required to sell your shares at the strike price (if the option is exercised).
Please note that covered calls are not suitable for every investor. You should carefully consider your investment objectives, experience level and risk appetite before entering into any options transactions.
How to Trade Options with Covered Calls
Step 1: Decide on the Underlying Security
When constructing a covered call, you must first decide on the underlying security. It can be any security, such as a stock, ETF, or futures contract.
For instance, let’s say you wanted to write a covered call on Singtel shares.
Step 2: Choose the Expiration Date
The expiration date is when the option expires and is no longer valid. The most common monthly and quarterly expiration dates for listed options in Singapore.
For our Singtel example, let us assume that we want to write a covered call with a monthly expiration date.
Step 3: Select the Strike Price
The strike price is how much the underlying security can be bought or sold for if the option is exercised.
In our Singtel example, let’s say we select a strike price of SGD3.50.
Step 4: Buy the Underlying Security
Once you have decided on the underlying security, expiration date and strike price, you will need to buy the underlying shares before you can write (sell) the call options.
In our Singtel example, we would need to buy 100 shares at SGD3.50 per share (SGD350).
Step 5: Write (Sell) the Call Options
The next step is to write (sell) 1 call option contract for every 100 shares of Singtel that you own. Each contract represents 100 shares of the underlying security.
The premium is how much the buyer pays the seller for the option.
For our Singtel example, let’s say the premium is SGD0.10 per share or SGD10 per contract (SGD0.10 x 100 shares). You will receive the premium as soon as you write (sell) the call options.
Step 6: Monitor Your Position
You will need to monitor your position regularly to see how it is performing. There are two key things that you need to watch out for:
- The Price of the Underlying Security: if the price of the underlying security increases, you may be “called away” and have to sell your shares at the strike price. However, if the price of the underlying security decreases, you will keep the premium as a profit.
- The Time Value of the Options: the closer the expiration date, the less time value the options will have. If the underlying security price is not moving in your favour, you may want to close your position before the options expire.
Covered calls are excellent for generating income from your existing long positions. However, you must be aware of the risks and carefully monitor your positions.
The Risks of Using Covered Calls
Risk 1: The Price of the Underlying Security Increases
If the price of the underlying security increases, you may be “called away” and have to sell your shares at the strike price.
Risk 2: The Time Value of the Options Decreases
If the underlying security price is not moving in your favor, you may want to close out your position before the options expire.
Risk 3: You Miss Out on Upside Potential
If the underlying security price increases significantly, you may miss out on upside potential as you have already sold your shares at the strike price.
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