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In the previous lesson, we learned about the fundamental concepts of combining options and why we engage in options strategies. Today, we will introduce the first common type of portfolio strategy - the Covered Call Option Strategy.

1. What is the Covered Call Option Strategy?

If you hold stocks and expect a modest increase in their future price, there's a strategy that allows you to earn extra income while holding onto your stocks. This strategy is known as the Covered Call Option Strategy! In simple terms, you can sell a call option contract while holding onto your stocks. Of course, it's important to choose a higher strike price for the call option. But why is that?

If the stock price rises, you benefit from the increase in the stock's value. However, if the price rise surpasses the strike price of the call option, as the seller, you might face losses on the call option. Therefore, the strike price of the call option should be set higher than the expected increase in the stock's price. This ensures a higher probability of fully capturing the premium income.

As a result, the optimal outcome of this strategy is if the stock price increases but remains below the call option's strike price. This way, you not only gain from the stock's price appreciation but also avoid the call option being exercised, enabling you to earn the premium and generate additional income.

2. Practical Application of the Covered Call Option Strategy

Let's consider an example: Currently, Alibaba's stock price is around $94. Suppose you hold this stock and anticipate a slight increase in its price to around $96 in the future. If you were to employ the Covered Call Option Strategy, you would first hold Alibaba's stock at a cost of $94. Subsequently, you would sell a call option with a strike price of $96 or even higher.

It's important to note that if the strike price of the sold call option contract is below $96, and the future stock price indeed rises to $96 or higher, the sold call option could result in a loss. Therefore, the strike price must be equal to or greater than $96 to mitigate this risk. Theoretically, the higher the strike price chosen, the lower the probability of a loss on the sold call option, but this also comes with the trade-off of lower premium income.

Let's assume we sell a call option with a $96 strike price and receive a premium income of $0.57. If the future stock price stays between $94 and $96, we not only benefit from the stock's price increase but also earn an additional $0.57 in premium income.

In other words, as long as the stock price doesn't exceed $96.57, the call option can provide us with extra income. The only risk is when the stock price rises above $96.57. As the seller of the call option, we would experience a loss in this scenario, and we would need to close the call option position promptly.

Alright, that concludes today's lesson. In the next session, we will learn about the Vertical Spread Strategy.