Stock Market Covered Calls Information

A call option gives the owner the right, but not the obligation, to buy a stock at a certain price, called the "strike price." The option seller takes on the obligation of selling that stock to the buyer should the buyer exercise the option. While the seller initially collects a premium from the buyer, the seller's risk is theoretically unlimited if the stock moves up. For this reason, selling covered calls--in which the seller already owns the stock he is selling the option on--is a more prudent strategy than selling naked calls, in which the option seller must purchase the stock at the possibly much higher market price and sell it at the option's guaranteed strike price if the option is exercised.

The Call Option

The option is a derivative investment vehicle. In other words, it is an instrument derived from some other underlying market. The stock market, currency market, commodities market and futures market all have corresponding options markets. The call option allows the investor to buy the underlying security at a predetermined price for a fixed period of time. For example, a call option on a stock that is currently worth $50 may offer the buyer the right to buy it for $54 at any time in the next 90 days--a right that could become valuable if the stock's market rises above $54 during that time. The price stated on the option is known as the option's strike price.

Buyers & Sellers

For every call option buyer there is a seller. When someone sells a call option, they receive a premium from the buyer. However, if the underlying stock rallies past the strike price of the option, the seller is obligated to sell the specified number of shares to the buyer at the option's strike price. In that case, the option buyer profits and the seller loses the difference between the market price and the option's strike price.

The Covered Call

As you can see, simply selling call options without owning the stock can be very risky. What if the theoretical $50 stock, for example, suddenly shot up to $1,000 a share? If she didn't already own the stock, the option seller would have to buy shares at $1,000 apiece in order to sell them for $54 apiece.

However, when someone sells call options on stock they already own, this is referred to as selling covered calls. Selling covered calls entails less risk than selling naked calls because the call option is covered by existing shares of stock. If the stock exceeds the strike price of the option, all the seller has to do is sell their existing shares to the buyer and their position will be closed out.

Covered Call Strategies

Covered calls are used to generate additional returns on an existing stock market position. For example, assume you own 100 shares of ABC stock. You expect the stock to go up over the long term, but you feel the stock will remain stagnant for the short term. If you sell a call option on ABC stock and the stock trades below the option's strike price through the option's expiration date, you keep the premium you received for the option which, on our theoretical $50 stock, could amount to a few dollars per share. On the other hand, if the stock breaks the strike price, you will have to sell your shares of ABC stock in order to meet your obligation to the option buyer, which means you will lose out on some potential market gains--but you won't be wiped out.

Options Only Strategies

There are also covered call strategies involving only options. It is not necessary to own any of the underlying stock to execute these strategies. One such strategy is the calendar spread. In this spread, the options trader sells a near-term call option and buys a long-term option on the same stock. The options share nearly all characteristics, except for the fact that the long-term call option has more time value. This is a covered call strategy because the long term option position covers the sale of the short-term call option, which limits any potential losses.

References

• Investopedia: Covered Call