What are covered calls and how to use them in trading?

Clare Louise

One favoured strategy that novice traders in Singapore often overlook in options trading is the covered call. This strategy allows investors to generate income from their existing stock portfolio while providing downside protection. A covered call involves selling a call option against an already-owned stock.

The seller (or “writer”) receives a premium payment in exchange for the obligation to sell the stock at a predetermined strike price if the option holder exercises their right to buy. This strategy is considered “covered” because the investor already owns the underlying asset and, thus, can deliver it if necessary. This article will discuss implementing a covered call in options trading, focusing on the Singapore market.

Choosing the right stock

The first step in implementing a covered call strategy is to select the right stock to use as the underlying asset. The ideal stock for a covered call should be one you already own and are willing to sell at a higher price if necessary. It should also have a relatively stable price with moderate volatility, so it does not fluctuate too much.

In Singapore, choosing stocks from the Straits Times Index (STI), which represents the top 30 companies listed on the Singapore Exchange (SGX), is advisable. These blue-chip stocks are considered more conservative and less volatile than smaller companies. Additionally, they tend to offer higher dividends, making them ideal for covered call strategies.

Before selecting a stock, consider its historical performance, financial health, and dividend payout ratio. Look for a stock that has shown stable growth over the past few years with consistent dividend payouts. Researching the company’s fundamentals and ensuring it is financially sound is also crucial.

Selling the call option

After selecting the stock, the next step is to sell a call option, which involves creating an options contract stating that you will sell your shares at a predetermined price (strike price) within a specific time frame (expiration date). The buyer of this call option pays you a premium upfront, which is your compensation for taking on the obligation.

Consider setting the strike price above your stock’s current market price when selling a call option. This way, if the stock’s price increases and the buyer exercises their right to buy, you will still profit from selling at a higher price than you paid. However, be careful not to set the strike price too high, as it may not get exercised, and you would miss out on potential profits.

Monitoring the stock’s performance

After selling the call option, regularly monitoring your stock’s performance is essential. If the stock price increases significantly, there is a higher chance that the buyer will exercise their right to buy the stock. In this case, you must sell your shares at the predetermined strike price, regardless of their market value.

On the other hand, if the stock’s price remains relatively stable or decreases, the call option may expire worthless. Therefore, you can keep the premium payment and continue owning the stock. However, if you no longer want to hold the stock, you can always buy back the call option at a lower price and sell your shares in the market.

Evaluating potential returns

Before implementing a covered call, evaluating the potential returns and risks is crucial. The premium from selling the call option provides a limited upside while owning the stock offers unlimited potential gains. However, you may face losses if the stock’s price drops significantly.

To calculate your potential returns, consider the premium received, strike price, and current market price. If the stock’s price remains stable or increases, you can collect the bonus and sell your shares at a higher price if exercised. However, you may face a loss if the stock’s value decreases significantly.

Rolling over options

Rolling over options is an essential aspect of covered call strategies. It involves closing an existing call option and opening a new one with the same expiration date but a higher strike price. It allows you to collect additional premiums and increase your profits.

However, be cautious when rolling over options, as it can result in losses if executed incorrectly. Consider the stock’s performance before deciding whether to roll over or let the call option expire.

Risks and considerations

Like any investment strategy, implementing a covered call involves risks that investors must consider. The main risk is losing the opportunity to profit from a significant stock price increase if you sell your shares at the predetermined strike price. Additionally, if the stock’s value drops significantly, the premium received may not cover the losses, resulting in a net loss.

Another consideration is that selling call options limits your potential gains on the underlying stock. If the market experiences significant growth and you no longer own the stock, you miss out on potential profits.

Consider that options trading requires a thorough understanding of its mechanisms and associated risks. Consult a financial advisor or conduct extensive research before implementing any options trading strategies.