Covered Call Basics

What Are Covered Calls?

Welcome to the Covered Call Basics page. So what are covered calls? In short, they are part of a relatively simple, popular, and conservative income-producing option trading strategy.

Covered Call Basics - An Overview

covered calls - rent or lease your stocks

Call writing has been compared to being a landlord of your own stock portfolio in that you're essentially leasing out shares of your stock.

I do like the landlord analogy. The premium you receive from selling a covered call is comparable to leasing income.

But with this strategy, comes an added twist - your tenant has the right to purchase the property outright from you at a predetermined price (i.e. the strike price of the call option you sold or wrote).

Quick Link - Basic Stock Option Definitions and Terminology

Here's how it works: For each 100 shares of stock you own, you would sell (or write) 1 out of the money call option. In exchange for the premium received, you in turn give the buyer of the option the right to purchase your 100 shares at any time prior to and including expiration at the strike price of the call option.

Note: More conservative approaches involve writing the call at the money or even in the money.

The benefit of writing calls at lower strike prices is that you gain greater downside protection and likelihood of a profitable trade. The disadvantage is that you give up higher potential returns.

As long as the call option expires out of the money (i.e. the strike price is higher than the share price), your stock is safe and you can repeat the process again and again.

Even if the stock does close a little higher than the strike price, you can always roll out the position, buying back the current call and selling another one the next month out at the same strike price (or possibly at a slightly higher strike price), and collecting additional premium.

If the stock continues to rise, it will eventually no longer be cost effective to roll out the position. You can quickly find yourself having to roll it out a year or two in the future just trying to keep the position alive.

And that's one of the biggest risks of the covered call strategy - the loss of potential large capital gains when the stock you own moves up in a big way.

The premium you receive is great when the stock is flat, and it even adds some downside protection if the stock begins to trend lower (you can calculate your stock position's adjusted cost basis as your original purchase price less the option premium received).

But if the stock ever explodes higher, you'll likely miss out on a huge payday.

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