Definition of Writing Covered Calls

Selling an options contract for equities you've already purchased is known in finance as "writing a covered call." This article will clarify the technical terminology, underlying mechanics and cash-flow generating opportunities of this interesting trading strategy.

In Plain English

"Writing a Covered Call" means that you own some equity (e.g. shares of a publicly traded stock) and decide to sell another person a contract that entitles---BUT DOES NOT REQUIRE---him to buy that equity from you at a pre-determined price.

Key Terminology

Option contract is an example of a "financial derivative," a product whose value is "derived" from the market value of some other product (e.g. shares of a publicly traded company).
A "Call" is type of options contract where one party is allowed BUT NOT REQUIRED to buy an equity (e.g. stock) from another party for a specific price at time within a set 3-week period. In exchange for this 3-week-long privilege, the first party pays the second party a small fee (known as "a premium"), which the latter gets to keep, regardless of whether the former chooses to exercise his privilege.
The first party (who pays the premium) is called "the buyer." The second party (who accepts the premium in exchange for the fixed-price liability) is known as "the writer" or "seller."

What Does "Naked Call" Mean?

Because options contracts are "derivatives," the seller/writer doesn't actually need to own the underlying equity/stock. If the writer of a call doesn't own the underlying stock and buyer exercises his privilege, then the writer must buy the stock at whatever the current market price is and sell it to the buyer for the price agree upon in the original contract. So, if the market value that day is $20 but the set price of the contract (known as the "strike price") is $12, the writer buys the stock off the market for $20 and then must sell it to the buyer for $12. The buyer would then sell the stock back to the market for $20, resulting in a $8 profit.
(NOTE: It may sound complicated, but this entire back-and-forth is executed by a giant computer at the Options Exchange in a matter of seconds, resulting in an $8 profit in the buyer's online trading account and an $8 loss in the writer's account).
A call contract where the writer/seller doesn't own the underlying equity---like this example---is known as a "naked call."

What Does "Covered Call" Mean?

The opposite situation, wherein the writer DOES own the underlying equity, is known as a "covered call." In the previous example, a covered call would've been one where the writer bought the underlying stock for $12 and then IMMEDIATELY wrote the contract with the "strike price" set at $12. When the market price for the stock went up to $20, the buyer would exercise his privilege and force the writer to sell him the stock for the agreed-upon strike price of $12. However, because the seller already owned the stock, he wouldn't have to pay $20 to obtain it from the market. Instead, the writer sells the stock to the buyer for $12, which is the price he paid originally!
Overall, the buyer still made $8 in profit but this time the writer lost nothing. In fact, because the buyer paid him a premium for the contract, the writer ended up making a small profit.

Benefits

Writing covered calls can be a great way to generate monthly cash flow in flat or non-volatile market while limiting your exposure to financial risk. For example, you can then take the cash generated by each month's contract premiums and use it to buy more underlying stock.
Which allows you to sell more covered call contracts.
Which increases the cash you get from contract premiums each month.
Which allows you to sell more covered call contracts.

Warning

Granted, this ever-growing cash flow model assumes that the market value of the underlying stock stays above the strike price for the contract month. If the market value doesn't go above the strike price, then you still get the cash from the premiums but now you're stuck with a bunch of stocks worth less than you bought them for. At this point, you either must sell the stocks for a net loss or hold them wait for the price to return to the value you bought them at originally.