Many new options investors start out by selling, or "writing", covered calls, so I thought it'd be helpful to take a closer look at how this strategy actually works. I've seen lots of discussions of "covered call writing" that explain the practice in theory, but don't really give you the real-world tips you need to use the strategy successfully in practice. Before we can dive into tips, though, let's start with first things first: what IS a covered call, and what does it mean to "write" one? What's a covered call?
A "covered call" is a strategy where you write call options corresponding to shares of stock you already own -- one contract for every 100 shares of stock you own. In other words, your obligation, as an option writer, is "covered" by your long stock position. When you write the call options, you earn an option premium and, in exchange, take on the obligation to deliver the underlying stock shares if the option is assigned and your shares are called away.
The benefit of a covered call strategy is that you keep the option premium when you write a covered call. If the underlying shares of stock never appreciate in value to exceed the call-option strike price, you realize the option premium as a gain. On top of that, if the underlying stock shares appreciate in value, but never reach the option's strike price, you may realize a gain from holding the underlying stock. If the options expire, and your stock shares are not called away, you can then sell new covered call options against the same shares of stock.
Although a covered call strategy is generally considered to be a more conservative options strategy, there are risks. First, there is downside risk from holding the underlying stock shares. If the value of the underlying shares falls significantly, the loss from holding the stock might far outweigh the gain from the option premium received. Second, the gain from owning the stock is limited to the gain (or loss) you realize when the share price reaches the strike price of the options. At this point, the shares will likely be "called away" and you will receive the exact strike price for the shares called away, but no more. In either case, you keep the option premium.
Covered calls can generate extra income above and beyond dividends, even if the underlying stock price remains static. This is called a "static return". Even if the price of the underlying shares goes up and your shares are called away, you can make a profit as described above. This is called an "if-called" return.
As a strategy, covered call writing can offer surprising benefits if you keep a few pointers in mind. Look for my next post to learn more...
Regards,
Brian (OG)
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.
