Sell Potential Upside On An Asset For Immediate Yield
Covered calls are a popular options strategy in which a trader sells an out-of-the-money call option on an asset while simultaneously holding the asset. This strategy allows traders to maintain their existing assets while generating instant yield from the contract's premium. This strategy is generally employed when your outlook on the assets price is neutral to moderately bullish.
There are now two possible scenarios: the asset's price is either below or above the strike price of the sold call options at expiry.
If the price of the asset remains below the strike price at expiry, the options are worthless and the user has earned the full premium as their return for the period.
However, if the price of the asset exceeds the strike price at expiry then the options will be exercised by their owner. Exercising the call options results in the owner purchasing the asset at the lower strike price instead of the current market price. As a result, the trader has now sold the underlying asset at a lower price point instead of benefiting from its full price appreciation.
Importantly, the trader's net position has appreciated in dollar terms since the start of the period as they have earned the yield from selling the options plus the appreciation of the underlying asset itself. That said, they have potentially underperformed simply holding the asset--depending on the magnitude of price appreciation and option premium earned.
The optimal outcome when running this strategy is for the price of the underlying asset to appreciate up to, but not exceeding, the selected strike price at expiry. This way, the trader benefits from the full price appreciation of the asset while earning an additional yield via the option premium received.
A covered call strategy is a relatively conservative, slightly bullish strategy. It is perfect for people who are moderately bullish and would like to generate additional yield on a given asset.
The risk profile of a covered call is dependent on the user's preferences and aggressiveness of the strike price selected. The closer the selected strike price is to the current price of the asset, the more likely it is to expire in the money and thus the higher the premium received. Therefore it comes down to the methodology for strike selection which is a function of the user's preference to sell the asset early in return for guaranteed yield. There is no right answer here and each trader will have their own market views and preferences.