The Covered Call: An Income-Generating Options Strategy

The covered call provides extra income to a buy-and-hold strategy. In exchange for this income, there is a risk of lost opportunity. If the stock’s price rises well above the fixed strike price of the call, you have your 100 shares of stock called away below current market value. For some investors, this is an unacceptable risk; for others, it is gladly accepted given the potential extra returns from writing covered calls.

A Few Options Basics

The popularity of options trading has grown in recent years. Many investors and traders have realized that options can be used not only to speculate, but also as a means for managing a long-term stock portfolio, taking profits without needing to sell stock, and reducing the threat of losses. Among the dozens of possible strategies, covered call writing is especially popular for its potential to generate extra income for a portfolio.

Options are intangible contracts that provide rights to their owners. A call option provides the right to buy shares. (The second type of option, the put, gives you the right to sell.) The stock involved in every call trade is the underlying security. Call options have two other specifications: the expiration date (the date on which an option expires and becomes worthless) and the strike price (the price per share at which 100 shares of an option can be bought or sold when exercised). None of these terms can be changed.

A buyer, or owner, of an option has the right to exercise the contract. In the case of a call, this means that the right involves “calling away,” or purchasing, 100 shares of the stock at the strike price. For example, if you own a 70 call and the underlying stock moves to $85 per share, that call gives you the right to buy 100 shares at $70, or $15 per share below current market value.

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