A covered call is a call option where you own the underlying stock. This differs from a naked call, where you do not own the stock.
Creating income by writing covered calls
Writing covered calls (a call option contract) is a technique for making money off of a stock that doesn't seem to be moving anywhere, but you are willing to sell once it hits a certain price.
The technique works as follows (Beware, these numbers are illustrative only):
- Buy (or already own) 100 shares of Stock A. The market price is currently $50 per share.
- There are $55 call option contracts selling for $1. Though the strike price ($55) of the option is less than the market price (out of the money), this option still has value due to the time-value or the option. This value will shrink the closer the option gets to its expiration date. Once an option expires, it is worthless.
- I write a call option contract with a strike price of $55, and then sell it for $1 per share, earning $100 less commission.
- Wait for the option to expire.
Two things can happen in the meantime:
- The price of the stock goes up and exceeds the strike price (in the money). At this point, the owner of the contract (Not you! Remember you sold the contract!) can exercize the option. You must sell the stock to the contract owner at the strike price, regardless of the actual market price of the stock. So if the price jumped to $70, you still have to sell at $55.
- The price of the stock doesn't exceed the strike price. Once the contract expires, you are no longer obligated to sell the stock at that price. Congratulations! You and your broker pocketed $100 and you still have the stock you started with.
Pros of this technique:
- Gets more income (positive cash flow) from a stock than the stock would normally give through dividends.
- Gives you the effect of setting a sell limit price with you broker, and earning money (through the contracts) as well.
Cons of this technique:
- If the price should go up quickly (and most major stock moves happen fast), you will not reap the entire benefit. You also cannot change sell limits quickly, like you can with a broker.
- If the price drops quickly, you may be unable to sell the underlying stock (due to margin limits or not being allowed to have naked calls) or if you do, you are then at a much higher risk of a quick upturn again, since you no longer own the underlying stock. (You've essentially turned a covered call into a naked call.)
The overall result is that you reduce your potential gain, and you also reduce your risk of loss, since you are making money over time.
Just remember, options are a derivative, they do not have any intrinsic value. Please make sure you understand them thoroughly before you invest.