In trading, the term covered call refers to an options contract which gives another party the right to buy underlying assets from another party at a fixed price within a certain time frame. It is called a covered call option because it is covered by actual assets owned by the writer of the option.
Covered call options are typically written by investors who own stocks and want to minimize their potential losses. In order to do this, the stock’s owner sells an option to another investor and charges an option premium. The option gives the other investor the right to buy the stocks if their price passes a predetermined threshold.
Example of a covered call option:
Investor A buys 1000 shares in a company’s stock for 10 Swiss francs per share, or 10,000 francs in total. Investor A then writes a covered call option which they sell to Investor B. The option gives Investor B the right to buy their shares if their value goes up to 12 francs per share or higher. Investor A charges Investor B an option premium of 1 franc per share, or 1000 francs.
If the value of the stock goes up to 12 francs per share, Investor B may exercise their right to buy the shares at 12 francs per share. Investor A would earn a profit of 2 francs per share (2000 francs in total) plus the option premium of 1000 francs. Investor A’s combined profit would equal 3000 francs. If the value of the shares increased far beyond 12 francs per share, Investor A would still earn just 3000 francs on the investment. Investor B, after exercising their option, would own the shares and profit from further capital gains.
If the value of the stock remained at 10 francs per share, Investor A would still profit from the 1000-franc option premium. So Investor A would still earn a profit even if the stock’s price remained stagnant.
If the value of the stock went down 9 francs per share, Investor A would not make a loss because the 1000-franc option premium would compensate for the 1000-franc capital loss. If the value of the stock declined further than 9 francs per share, Investor A would make a loss, but the loss would be lower than it would otherwise have been because the 1000-franc option premium acts as a buffer against loss.
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