Covered calls can perform several functions for the “seller” known as the writer of the option, and also the buyer or holder of the option contract. Selling a contract allows a way to derive income from an underlying equity, that being a marketable stock or commodity. Another function is that it allows a seller to set his own price. The buyer is making the opposite bet on the future price of the stock, which in a covered call transaction would be a anticipated decrease in the stock price.
These functions combine together, and allows two different beliefs about where the future value of the stock is heading, to bet upon. It may seem unclear at first glance, but once the basic’s are understood, then the benefit and the utility behind options emerge, along with the practicality and ability to hedge risk or create it.
The origin and history of this type of trading began with commodities. Consumers of such staples as seed, rice, wheat, corn, and cattle wished to have a way to lock in a price at which to buy the commodity out into the future at. This would protect them against sudden and unexpected increase in prices and assure them of a guaranteed supply.
The producer wanted to assure that the value of his commodity did not fall. This hedging by means of a futures contract provided just that mechanism. Both sides of the coin wished to protect their interests out into the future. This gave rise to the options market as we know it today.
The modern day options market provides the same essential function. There still exists the same dynamic between producers and consumers of commodities. The benefits enjoyed by the commodity producers and consumers lent itself well to serving the same function on behalf of stock and bond holders.
Most options are never exercised in the physical sense where the under-lying stock actually changes hands. It most often is strictly a paper transaction. It is impractical to carry the transaction to it end, so most often it is simply traded out from or covered by an opposing position. When a covered call option expires un-exercised, then there is an unhappy buyer and a very happy seller.
Contracts are standardized in lots of 100 shares each, accordingly 5 contracts represents 500 shares. Rights and obligations are in essence what is being bought or sold. This is what must be understood to appreciate the true nature and what actually is being conveyed in such a transaction.
The buyer or holder of the option is securing a right, which enables him to purchase the shares of a company, at a agreed upon price, up to a certain date into the future. The seller of a covered call option seeks to realize an additional means to profit from a stock holding, in a way that does not rely upon dividends, earnings per share, or a rise in the stocks price.
The are two ways in which a seller of covered calls can hope to profit from his options contract.One way is to plan on selling the options on a stock before he owns it, thus the income from the sale of the contract he wrote reduces his cost of purchasing the stock. The second way is employed by many sellers of covered call options contracts, which is to sell a contract and hope that is will expire. This allows them to keep the income from when they sold the contract. It is another way to make a profit other than earnings, dividends, or a rise in stock price that you sell into.
Understanding the top option trading strategies will help you be a successful market trader. Covered calls make it possible to protect your investment.