Understanding Covered Calls

Covered calls, also known as buy-writes, are conservative options trading strategies employed primarily by professional investors. Individual investors can also use the strategy, once they understand the concept. Covered calls are widely used basic strategies for combining option ownership simultaneously with stock ownership, allowing the investor to profit in more than one way.

Definition

Call options are contracts giving the buyer of the option the right, but not the requirement, to buy 100 shares of the underlying stock at the strike price at any time before the option expires. The strike price is the predetermined price for selling the stock before the option's expiration date. The call option is considered to be covered if the seller already owns the shares of stock, as they can deliver them to the buyer without purchasing them in the open market.

Function

The buyer purchases the right to buy shares at a predetermined price in the future by paying the seller a premium. The premium is a fee paid to the seller in cash on the day the option is sold. The seller keeps the premium whether or not the buyer exercises the option. For example, assuming you paid $100 per share for 300 shares of ABC stock and you believed the stock would rise to $150 per share within the next year, you may want to sell 100 shares for $125 during the course of the year to make a short-term profit.

Significance

Once you decide to sell part of your shares for a quicker profit, you would peruse the stock's option chain for potential buyers. Imagine that you find a $125, six month call option selling for $5 per share. You could sell the $125 call option against your shares that you purchased for $100 each. By doing so, you obligate yourself to sell the shares at $125 during the next six months, if the market price of the stock reaches this amount. The buyer would pay you $5 in premiums on the day you sold the call option. If the option is exercised, you would still have made $130 per share for your stock, $125 for the call option and $5 for the premium. Your call option is covered since you already owned the stock before you sold the option.

Benefits

Selling covered calls work in your favor if you are right about the direction the stock is heading. Though you do not receive your target profit, you still make money on the stock that you own. If you sell a covered call and the option is not exercised, you still keep the premium, so your losses are less.

Considerations

Covered calls generate income regardless of the market price of the stock. You could make less profit if the option is exercised, but you could also hedge your losses if the stock does not perform as you thought it would. The risks of purchasing call options are the same as the risks for buying and selling any type of stock. You assume those risks as an investor. Covered calls offer a way to offset those risks. By accepting the premium from the buyer, your total costs for the price per share of stock is reduced if the stock goes to zero or below the price you paid for it. The other risk involved with selling a covered call is that you will make a reduced profit if the option call is exercised and the price of the stock keeps rising.

Resources

• Understanding Covered Calls