10 Covered Call Terms You Should Know
Under certain circumstances, call options can be a valuable tool for generating additional income and reducing concentrated stock positions at specific selling points.
However, options trading comes with its own unique terminology, which can sometimes be confusing. In this post, we share 10 essential Covered Call terms to help you navigate this space.
1. Call
This is a type of exchange-traded contract that grants its buyer the right—but not the obligation—to purchase a specific quantity of a stock or exchange-traded fund (ETF) at a predetermined price before or on a set expiration date.
2. Underlying Asset
The stock or ETF that the call gives its buyer the right to purchase. Options are often referred to as "derivatives" because their value is derived from the price movement of the underlying asset.
3. “Covered”
A call is considered “covered” when the seller owns the underlying asset. This strategy helps manage risk. In contrast, selling an uncovered (or "naked") call is highly risky because it may require the seller to deliver shares they don’t own, potentially leading to unlimited losses.
4. Strike Price
The price at which the call buyer can purchase the underlying asset. The call buyer hopes that the market price of the underlying asset will go above the strike price (i.e., be “in the money”). In contrast, the call seller does not want the market price to exceed the strike price until after the option’s expiration date (i.e., remain “out of the money”).
5. Expiration Date
The specific date on which the option expires - typically after market close on a Friday. After this date, the option is either exercised (if in the money) or it expires worthless.
6. Premium
The price that the call seller receives for selling the option. The premium is received at sale and is taxable in the year that the option expires or is exercised.
7. Exercise
When the call buyer decides to activate the option to purchase the underlying assets at the strike price. Buyers typically wait until the expiration day to exercise their options as this gives them maximum time for the underlying asset to increase in price, thereby increasing their profit. However, they have the right to exercise earlier if they’d like.
8. Assignment
When the buyer exercises their right to purchase the underlying assets at the strike price, the call seller is obliged to sell those assets to them (i.e., the call seller is “assigned”).
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9. Break-Even Price
This is the effective price of the underlying asset after accounting for the premium received. As premiums are received, the break-even price decreases. However, severe declines in the value of the underlying asset will generally outweigh premiums received.
Break-even price = purchase price of the underlying assets - premium(s) received.
10. Roll-Up
This is a strategy pursued by call sellers when the option is “in the money,” and they do not wish to be assigned. A roll-up involves buying back the option (typically at a loss) and then selling a new call option (with a higher strike price and distant expiration) to cover the cost. This strategy can allow the call buyer to retain the underlying asset for longer and participate in more capital gains of the underlying asset.
Final Thoughts
Options can be a powerful tool for enhancing portfolio returns and managing risk, but understanding their mechanics is key to making informed decisions. By understanding these covered call terms, you'll be better equipped to navigate the options market with confidence.
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