Finance: What is a Covered Call?

What is a Covered Call? In order for options to be traded, someone has to write them in order for them to be available in the market. The majority of call options, which gives the owner the right to purchase stock at the strike price before the expiration date, are covered calls, meaning that they are written against an equivalent amount of stock or other calls at a lower strike price in the writer’s possession. To be naked, meaning to not own any underlying security or derivative, the writer must have sufficient account margin to cover the option in the event it is exercised.

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Transcript

00:18

a hundred bucks a share You've owned it since the

00:20

stock was at forty bucks a share in Well frankly

00:22

you're getting a bit nervous about mickey and minnie being

00:27

oh so out of date And you're worried about disney's

00:30

broadcast licenses being well useless as people watch tv over

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the internet someday So you are looking for a time

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to sell but i just don't know when And at

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one hundred the stock is not like a screaming immediate

00:44

cell but well let's put it on the macy's white

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flower day sale rack Okay what can you do here

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You can sell a covered call like you sell someone

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else the right toe by your disney shares at one

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hundred seven dollars Fifty cents a share Any time in

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the next six months and you sell that right Forfour

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bucks to wait What does all this mean Well you

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just got a cash wire into your brokerage account for

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four bucks Free money issue if the stock stays flat

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at one hundred or actually anywhere below one hundred seven

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dollars fifty cents which is the strike price at which

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you sold your call Well for the next six months

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that is until that call expires Well the nothing else

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happens You keep your four bucks a share and yes

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you'll pay ordinary income tax on it Eventually the gal

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who paid you that four bucks feels like an idiot

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as she has just lost one hundred percent of her

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four dollar investment to you who smiles wryly because you

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know what kenny rogers says about that poker table You

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gotta know when to hold them No one to fold

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them but you don't do anything and you move on

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and you know you go buy your wife a nice

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steak dinner So what happens if the stock rockets to

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one hundred twenty during this period and your shares are

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called away That is at one hundred seven dollars fifty

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cents That's what You get paid and you got your

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four boxes One eleven Fifty total that you collected and

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they're called away and yes you feel bad Maybe you're

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the idiot this time you'll be forced to sell those

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shares to her One of seven fifty was the price

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with the stock Now at one twenty you'll have lost

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twelve fifty in game but don't forget that you took

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in four bucks six months ago So you had a

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little time value of that money and appreciation of it

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you know working for you but yeah you just got

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four bucks And so you subtract that from the twelve

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fifty and gain And yes you lost eight Fifty and

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potential gains versus just waiting being patient and then selling

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the stock at this point at one hundred twenty bucks

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a share And yes for you nerd lingers in the

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back row Disney does pay a dividend as well So

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you did keep clipping that coupon during those six months

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while you owned the stock All these air reasons why

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you might want to look hard It covered calls when

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you want to get out of the stock but the

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current price isn't quite your target's cell price All right

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so what happens if stock craters and it goes to

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etienne six months Well you took in the four box

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when the stock was at one hundred in return for

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selling that covered call So none of the four bucks

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you collected well your feeling like you owned the stock

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at ninety six dollars a share rather than one hundred

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So you quote lost unquote notionally sixteen dollars instead of

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twenty doesn't make you feel gray like you could have

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just sold the stock and a hundred bucks a share

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It just makes you feel well less awful The basic

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idea is that covered calls are covered because you own

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the shares underlying them If you didn't own any shares

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i eat your call option wasn't covered by them and

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you just sold a naked call iii with no other

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related assets beneath that derivative Then the risk profile of

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that trade changes dramatically That is while the stock was

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trading at one hundred bucks a share you sold someone

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a call option for four bucks with a strike of

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say one hundred ten dollars share to make the math

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easy Good for the next five months then the stock

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rockets to one hundred twenty five dollars a share do

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you collected four dollars in premium up front from selling

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that call option But now you have to go out

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into the market and deliver to that buyer of the

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call option a whole bunch of shares which now you

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have to pay one hundred twenty five dollars each For

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that pleasure you know be careful Basic idea Kids don't

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try this at home This domain is only for professionals

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who were trained most of whom are smarter than we

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are And they know how easy it is to go 00:04:30.425 --> [endTime] very bankrupt very quickly