A covered call in the UK is a financial market transaction in which the seller of call options purchases an equivalent amount of the underlying security, such as a UK stock or bond, to hedge their position. This trading strategy is used when the investor expects the underlying asset price to remain relatively stagnant or decrease slightly soon. If you are interested in using this strategy, you can ask a reputable financial advisor such as Saxo Bank if you have any questions about implementing this.

The key to this plan is the Call option. A call option allows the holder the right, but not the obligation, to acquire 100 shares of an underlying security at a set price within a limited period. The buyer pays a high price for this right. If the underlying security price goes above the strike price before expiration, the buyer can exercise their option and purchase shares at a discount.

If the underlying security price goes down, the option will expire worthlessly, and the buyer will only be out the premium paid, and this is where hedging comes in. By simultaneously buying the underlying security, the trader limits their downside risk should the asset price fall.

Covered calls are a popular strategy among traders looking to generate income from their portfolio while maintaining some upside potential. This strategy can also hedge against downside risk in a declining market.

How does a covered call work?

To construct a covered call, a trader buys (or already owns) an asset and sells call options on that same asset. The number of options sold should equal the number of shares owned. For example, if an investor owns 100 shares of XYZ stock, they would sell one call option for each share.

The trader receives a premium from the sale of the options, which offsets some downside risk should the asset price decline. If the underlying security price remains stagnant or falls, the call options will expire worthlessly, and the trader will keep both their asset and the premium.

However, if the underlying security price rises above the strike price before expiration, the call buyer may exercise their option to purchase shares at a discount. The trader is then forced to sell their asset at a lower price than it is worth, but they offset this loss with the premium received from selling the call options.

Covered calls are a popular strategy among traders looking to find new opportunities using their portfolio while maintaining some upside potential. This strategy can also hedge against downside risk in a declining market.

When to use a covered call?

A trader might use a covered call in a few different scenarios.

If the UK trader is bullish on the underlying asset and expects it to rise but wants to generate income from its position, it can sell call options against its holdings. If the price does indeed rise, they will be able to take advantage of both their asset and the option premium. However, if the price falls or remains stagnant, they will only lose the option premium.

If the UK trader is bearish on the underlying asset and expects it to fall, they can sell call options to hedge their position. If the price falls, the option will expire worthlessly, and they will offset some of their losses with the premium income. If the price rises, they may be forced to sell their asset at a lower price than it is currently worth, but again, this loss will be offset by the premium income.

Covered calls are also sometimes used to manage risk in an existing portfolio. By selling call options against holdings, traders can minimise downside risk while maintaining some upside potential.

Pros and cons of covered calls

Like any financial market transaction, covered calls have advantages and disadvantages.

Some advantages include the following:

• Limited downside risk
• Ability to generate income from a portfolio
• Hedging against a declining market

Some disadvantages include the following:

• Forgoing potential opportunities if the underlying asset price rises significantly
• The trader may be forced to sell their asset at a lower price than it is currently worth

The bottom line

Covered calls can be a helpful tool for traders looking to identify opportunities in moving markets or hedge their investments. However, it is crucial to understand the risks and rewards before entering into any transaction.