Buying of options is considered a safe way of trading in the stock market especially in volatile situations where there are rapid and sharp movements in stock prices. While option buying is allowed to all, selling an option is a risky proposition for a retail investor and hence restricted by many brokerages.
Options may be call options or put options.
A call option gives the buyer the opportunity but not the obligation to purchase the underlying stock at the agreed upon price (strike price) on or before the date of expiration, when it is an American style option.
Selling a call option is called call writing. The seller of the call option has the obligation to sell the underlying stock at the strike price when the call option buyer exercises his option.
A covered call means that the investor already owning the underlying stock sells call options of the same, thus limiting his risk if the market were to move downward resulting in a fall in the price of the underlying.
Today, we have covered call ETFs (Exchange Traded Funds), an innovative product offering for the retail investor.
An exchange traded fund is a basket of stocks that is bought and sold on a stock exchange as if it were one single stock. Typically, stocks comprising an ETF belong to one sector or are part of one particular index.
Exchange traded funds which adopt the strategy of covered calls are called covered call ETFs. These funds buy stocks of the underlying index and at the same time sell the call options of the same index whose strike prices are at or above the current index level. These ETFs are also called buy – write exchange traded funds.
In a raging bull market, investors who have put their money in covered call exchange traded funds will not be able to fully benefit from the rising stock prices. This is because; the significant increase in the prices of the underlying stocks will lead to a rise in the obligations of the investors to the purchasers of the call options.
It would not be out of place to mention that there are options with the ETF as the underlying. Many investors follow the covered call strategy in exchange traded funds where in they sell call options of the particular ETF in which they are invested.
Covered call ETFs (Exchange Traded Funds) are popular among investors when the markets are flat and they are unsure of the market direction in the short term. Option trading also holds some kind of fascination for the retail investor and exchange traded funds have been able to exploit this by offering this seemingly exotic product.