Mainstream investors buy assets they think will go up. If the asset price stays the same or goes down the investor gets no profit or a loss. Covered calls are a way for investors to show a modest profit if:
- The asset goes up in price
- The asset price stays the same
- The asset price drops a relatively small amount
One of the catches (and there are always at least one), is that the investor gives up some upside. If the asset goes up dramatically in value the covered call holder typically does not enjoy most of that increase. Another catch, and I think this is the biggest one–if the investor is really wrong, and the asset tanks, the losses are essentially the same as the mainsteam investor would suffer.
With a covered call, the investor generally has given up the possibility of a big gain, but can still experience major losses–a disconcerting asymmetry.Countering this risk, is my favorite aspect of covered calls–if the asset price just fluctuates, without going anywhere, I can still make a modest profit. Since assets spend most of their time going sideways, fluctuating around this is a very attractive.For me there is an important personal benefit: It slows me down. If I just buy a stock, I want to sell it as soon as I get a modest profit. If that same stock is in a covered call position the gain is muted short term but I am rewarded with increasing profits if I hang on.
So what actually is a covered call? I am not going to give a full tutorial here. There are many on the web. Briefly it is a position where you buy an asset (e.g., stock, ETF) and sell (create) a option on it. The potential losses on the option you sell are completely neutralized because you own the underlying asset. Since this option you are selling has value, the market will pay you immediately for its value. If the asset price stays the same, increases, your position will be profitable when the option terminates (expires, or assigned). If the asset price declines significantly, the value of the option sold helps mitigate that loss, but you can still take significant losses. For this reason, covered calls should only be used if you are neutral or bullish on the asset, or you have a strategy for limiting your losses (e.g., exiting, taking your losses at a certain point).
Covered calls take a lot of capital to put in place. Since options typically come in units corresponding to 100 shares of stock, the minimum bet requires you invest nearly that much. For Google at $600 / share the table stakes are $60K! While this is unusually pricey, many assets are priced around $100 / share, so a $10K minimum investment is required, and at this levels commisions can significantly reduce profits.