How a covered call works
A buyer of a call option will generally exercise his or her option if the stock price is above the strike price and not exercise if it is below.
(Editor’s note: Do not read the following ideas as a recommendation. Do further research of your own or talk to a financial adviser before acting on themes in this article).
Let us say, for example, you sold a Sydney Airport (ASX: SYD) call option with a strike of $5.90 for 15 cents. In both scenarios, you keep the 15 cents premium as a cash profit.
If SYD rallies and is now trading at $6.00, it makes sense for the buyer to exercise the option and buy your stock off you at $5.90, 10 cents cheaper than off the market. This option is called in-the-money (ITM).
On the flip side, if SYD drops to $5.80, the buyer of the option likely won’t exercise as the stock can be bought off the market for 10 cents cheaper. The option expires worthless and is called out-of-the-money (OTM).
The goal of a covered call, especially if you want to keep the stock, is for the call option to expire OTM.
The risk of an exercise can be eliminated, however. By selling a European option [a European option refers to contracts that give the investor the right to buy, or sell, an asset at a specific price on a certain date], the buyer can only exercise the option on the expiry date. This allows you to buy back the option from the market if the option is ITM and you want to avoid exercise.
Pros and Cons
The key is knowing what stocks this strategy is best suited for, to minimise the cons.
This strategy is a great way to generate a monthly income on a stock that is range-bound by selling an option at the top of the range. As an example, SYD could be a candidate for this strategy because of its range-bound stock price due to closed borders, in my opinion.
However, this is also a risk. If our borders open and SYD rallies, this strategy will cap the upside that you would participate in if you only held the stock.
With that in mind, picking the right stock in the right environment can make the covered call strategy a highly lucrative one.