What Is a Covered Call? A Comprehensive Guide
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Are you looking for an investment strategy that allows you to generate income while mitigating risk? Covered calls might be the answer you’ve been searching for. In this comprehensive guide, we’ll take a deep dive into the world of covered calls, discussing their mechanics, implementation, benefits, drawbacks, and even tax considerations. By the end of this post, you’ll have a solid understanding of this versatile strategy, and be equipped to answer the question, “what is covered call?” to decide if it’s the right fit for your investment portfolio.
Key Takeaways
Covered calls are an options strategy that enables investors to generate income from their existing cryptocurrency.
Covered call strategies involve analyzing price stability, volatility, dividend payments and intended results in order to optimize income generation and risk management.
Selling covered calls can provide a steady monthly income of around $3,000 or $36,000 per year with the potential for tax advantages when utilized in retirement accounts.
Demystifying Covered Calls
Covered calls are a popular options strategy that involves covered call writing, which means to sell covered calls on crypto you already own. This enables you to earn extra income from the premiums received, while you continue to own the underlying asset.
At the core of the covered call strategy are two essential components: the call option and the underlying cryptocurrency. We will delve into the specifics of each of these components.
The Call Option
A call option is a contract allowing the buyer to buy tokens or a futures contract at a set price (also known as the strike price), before the option’s expiry. This gives them the legal right to do so. Call options are priced using mathematical models such as the Black-Scholes or Binomial pricing models, with the price determined by parameters like:
the cryptocurrency’s spot price
strike price
time to expiration
volatility
risk-free interest rate
The interplay between option pricing and the underlying cryptocurrency plays a key role in covered call strategies. A covered call strategy involves holding a long position while selling call options on that same cryptocurrency. This approach can provide potential income in neutral to bullish markets and may also offer a selling price above the current cryptocurrency price in rising markets.
Owning the Underlying Cryptocurrency
Executing a covered call requires ownership of the underlying cryptocurrency, which guarantees that you can deliver the tokens if the option is exercised. In a covered call, you sell a call option on the crypto you already own, which serves as a ‘cover’ for the call option. This position provides downside protection and generates income through the sale of call options.
To sell a covered call, you must possess at least a percentage of the underlying crypto. Without ownership of the underlying crypto, it’s not possible to execute a covered call strategy.
Implementing the Covered Call Strategy
Having understood the basics, it’s time to examine the procedure of implementing a covered call strategy. This involves selecting a stable cryptocurrency, selling call options with your chosen strike price, and setting an expiration date.
During this process, factors such as the cryptocurrency’s price stability, volatility, dividend payments, and your intended result should be taken into account. By carefully analyzing these elements, you can optimize your covered call strategy for maximum income generation and risk management.
Choosing the Right Cryptocurrency
A key aspect of choosing a crypto for a covered call strategy is to prioritize stability and low volatility. Stable cryptocurrencies minimize the risk of price fluctuations and enable you to generate consistent income from selling call options. To evaluate a crypto’s stability and its potential impact on crypto prices, you can use the following tools:
VIX
ATR (Average True Range)
Standard deviation
Choosing low volatility crypto is particularly advantageous for covered calls, as it reduces the risk of the option being exercised. This strategy helps in creating a steady income flow while reducing the likelihood of losing the underlying crypto.
Picking the Strike Price and Expiration Date
Choosing the most suitable strike price and expiration date is a crucial step in your covered call strategy. The strike price should be chosen above the current cryptocurrency price, but within a range that you’re comfortable with. You may also want to consider using technical analysis to identify resistance levels on the chart to determine the best strike price.
When it comes to setting the expiration date, it’s important to balance income generation with risk management. Here are some considerations:
Longer-dated options (between 90 days and six months) may require less management but have lower returns and potentially higher risk.
Shorter-dated options (between 30 and 60 days) may offer higher returns but require more active management.
The expiration date plays a role in determining the premium of a covered call, so make sure to take this into account when planning your strategy.
Benefits of Selling Covered Calls
Selling covered calls offers several significant advantages, such as generating income and reducing risk. By selling call options, you can generate income from the premiums received while still retaining ownership of the underlying cryptocurrency.
We will now examine in greater detail these two main advantages of selling covered calls: generating income and mitigating risk.
Income Generation
Selling covered calls can generate additional income that supplements your investment returns. When you sell a call option, you receive a premium that can be retained as income. Furthermore, selling covered calls enables you to establish a predetermined sale price for the cryptocurrency and generate additional income periodically.
The average income potential when selling covered calls can vary, but traders generally aim to achieve a consistent monthly income of around $3,000 or $36,000 per year.
Risk Mitigation
Covered calls can also help mitigate risk by providing downside protection and generating income. If the cryptocurrency price decreases, you still own the cryptocurrency and can benefit from any potential recovery. Additionally, by selling the call option, you receive a premium that can help offset potential losses.
It’s worth mentioning, though, that the downside protection offered by a covered call strategy is constrained to the received premium. This means that if the cryptocurrency price drops significantly, you may still incur losses.
Potential Drawbacks of Covered Calls
Despite the benefits of covered calls, there are also potential drawbacks to consider. The two primary disadvantages of a covered call strategy are the capped upside and increased transaction costs.
We will now scrutinize these potential disadvantages and their effect on your covered call strategy.
Capped Upside
The capped upside in a covered call strategy means that you may miss out on potential gains if the cryptocurrency price rises significantly. With a covered call, the upside potential is limited to the strike price plus the premium received from selling the call option. Consequently, if the cryptocurrency price surpasses the strike price, the additional gains will not be realized by the investor.
You can mitigate the risk of capped upside by choosing cryptocurrency with little potential for significant increases or by adopting a collar strategy. This involves buying a protective put option to restrict downside risk while selling a covered call option for income generation.
Transaction Costs
Transaction costs, such as commissions and fees, can eat into the profits generated from selling covered calls. These costs may include brokerage fees, commissions, and other charges associated with executing the trade. Consequently, it’s important for investors to factor in transaction costs when evaluating the possible profitability of covered calls.
To minimize transaction costs, consider using a low-cost broker or trading platform that offers competitive pricing for options trading.
Ideal Scenarios for Using Covered Calls
Covered calls work best in situations of market stagnation or low volatility, where major price movements are unlikely. In these situations, you can maximize income generation and minimize risk by selling covered calls on stable, low-volatility cryptocurrency.
We will now examine the best situations for using covered calls, with an emphasis on market stagnation and low volatility.
Market Stagnation
Market stagnation occurs during periods of minimal or no movement in the overall market. In such scenarios, the profitability of covered calls can be impacted due to limited potential for income generation and reduced option premiums. However, covered calls can still be profitable in flat markets, as they offer a way to generate income even when the market does not rise.
By selecting stable cryptocurrency with limited upside potential and selling covered calls on these crypto, you can capitalize on market stagnation and generate consistent income.
Low Volatility
Low-volatility cryptocurrencies are ideal for covered call strategies, as they minimize the risk of the option being exercised. When volatility is low, the premiums received from selling call options tend to be lower, which reduces the probability of the cryptocurrency price reaching the strike price and the option being exercised.
By focusing on low-volatility crypto and selling covered calls on these cryptos, you can generate steady income while minimizing the risk of losing the underlying cryptocurrencies.
Tax Considerations and Retirement Accounts
Before you implement a covered call strategy, it’s crucial to contemplate the likely tax consequences and the involvement of retirement accounts like IRAs. Covered call strategies can offer tax benefits, but there are also restrictions to be aware of.
This section will cover the tax implications of covered calls and their application in retirement accounts.
Tax Implications
The tax implications of selling covered calls can impact your overall investment returns. In the United States, profits from covered calls are generally considered short-term capital gains and are subject to taxation at your ordinary income tax rate. However, there may be tax benefits associated with selling covered calls within an IRA or other retirement account.
It’s always a good idea to consult with a tax professional or accountant for more specific guidance on the tax implications of selling covered calls and how to offset any losses you may incur.
Covered Calls in IRAs
Selling covered calls within an IRA or other retirement account can offer tax advantages, such as deferring or exempting profits from taxes. However, there are limitations and restrictions associated with the use of covered calls in an IRA, which can vary based on the custodian and your eligibility to trade options.
Before employing covered calls in a retirement account, it’s crucial to seek advice from a tax professional or financial advisor to ensure compliance with any applicable rules and regulations.
Real-Life Covered Call Example
To better understand the covered call strategy, let’s consider a real-life example. Suppose you own 100 tokens of a cryptocurrency, currently trading at $50 per token. You decide to sell a call option with a strike price of $55, expiring in 30 days, and receive a premium of $2 per token for the option.
If the crypto price remains below $55 at expiration, the call option will expire worthless, and you’ll keep the $200 premium as income. However, if the crypto price rises above $55, the call option may be exercised, requiring you to sell your tokens at the $55 strike price. In this case, you’d still keep the $200 premium and make a capital gain of $5 per token, resulting in a total profit of $700.
Summary
Covered calls are a versatile investment strategy that can help generate income and mitigate risk. By understanding the mechanics, implementation, benefits, drawbacks, and ideal scenarios for using covered calls, you can make informed decisions about whether this strategy is right for your investment portfolio. As always, consult a financial professional before making any investment decisions and consider the tax implications of your chosen strategy.
Frequently Asked Questions
How does a covered call work?
A covered call strategy involves selling out-of-the-money calls on the cryptocurrency owned, with the potential to earn income if the price stays below the strike price. The investor sells a call option against a long position in an asset and keeps the premium if the crypto finishes below the call's strike price.
Do you lose money selling covered calls?
When using a covered call strategy, losses may occur if the cryptocurrency price drops below the breakeven point. Furthermore, investors may miss out on opportunities for higher returns if the price rises above the effective selling price of the covered call. Therefore, it is important to calculate the static and if-called rates of return before entering into a covered call as these can indicate whether money will be lost or gained.
Why would you buy back a covered call?
Closing a covered call before it expires can be a smart move if the cryptocurrency price has gone up significantly, since you can buy back the option for a profit due to the lower option premium. Additionally, you can take advantage of the price increase and sell another call with a lower strike price that will generate more option premium and increase the chance of making a net profit.
What is a covered call simple example?
A covered call is an options strategy in which an investor holds a long position in an asset and writes (sells) call options on that same asset to generate income. For example, suppose an investor owns 100 tokens of XYZ cryptocurrency trading at $45 and wants to receive additional income in exchange for giving up upside potential. In that case, they can sell a near-month call option with a strike price of $50. If the cryptocurrency reaches this level, they will receive payment of the option premium in exchange for the option buyer taking ownership of the cryptocurrency.
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