What is a Covered Call Option Trade?

Generate Income by Writing Calls on Stocks You Already Own

Sep 29, 2009

Though there's no such thing as risk-free investing, investors can tip the risk-versus-reward scale in their favor by writing covered calls on stocks they already own.

While most conventional, buy and hold investors don't want to add to their risk or volatility by getting involved in the option market, selling covered calls may be a worthy exception. The risk is minimal, the potential profit is fair, and the execution of the trade is simple. An example will illustrate just how simple this income strategy can be.

Call Option Basics

A couple of definitions- possibly just refreshers- are in order to fully understand how a covered call strategy works.

A 'call option' is a contract that gives its owner the right to buy 100 shares of a certain stock at a certain price within a certain timeframe. The owner of a call option is not required to utilize that right (and may not want to if it will end up costing more than it's worth).

The seller of a call option (remember there's a seller for every buyer) however, is obliged to deliver those 100 shares of that stock at the strike price if the owner of the call chooses to exercise that right.

For instance, if the owner of an IBM February 90 call contract wanted to exercise his right to purchase 100 IBM shares at $90 each, he/she would pay $9000 to the investor who had 'sold' the contract, and 100 shares of the stock would be 'delivered' to the contract's owner.

Note that the contract's seller doesn't actually have to own those 100 shares of IBM to enter the contract... though not owning them means he may have to buy them at a much higher price in the open market- if the option's owner decided to exercise his right. That's the risk of writing uncovered calls.... IBM could be at $100, or $200, or more, and that option seller would still have no choice but to buy and then deliver IBM shares to the buyer of the contract.

The term 'covered' describes the scenario where a contract seller already owns those 100 shares to deliver if the option contract owner decided to exercise his/her right. The contract is said to be covered, since the shares won't need to be purchased in the open market.

Example of a Covered Call Trade

The descriptions above certainly seem to favor the owner of the call option, and appear to be very unfavorable to the seller of the contract. That's a superficial assumption though- there's something in it for the contract seller (or 'writer') as well... cash, and sometimes quite a bit of it.

Sticking with the IBM example, assume IBM shares are currently trading at $80 per share, and the current month is August. Since the calls are out of the money but expire six months later, the February 90 contracts would probably be worth somewhere around $3.50.... or $350 for the entire 100 share option contract.

The owner of 100 shares of IBM (or any multiple of 100) could collect $350 per contact if he/she were willing to sell covered calls.

Moreover, that investor may be able to sell (forced to, technically) those same shares at a price of $90 sometime within the next six months to the very same option buyer that paid $350 per contract when the contracts were first sold. However, he'll at least retain the full $350 in proceeds for the original sale.

The risk to the contract buyer is that IBM may by under $90 the entire six month period, so exercising the right to buy at $90 would never be advantageous.

The risk to the seller is that IBM will be worth more than $90 within the six month window, and his/her shares will be 'called away' at a price under the market price at the time. Bear in mind, however, that risk may be worth the reward to that particular investor.

The option seller's (the covered call writer's) ideal scenario would be that IBM shares trade under $90 the entire six month period and then move above $90 after the contract expires and can no longer be exercised.

Cases Where Selling Covered Calls Make Sense

Cases Where Selling Covered Calls Doesn't Make Sense

The copyright of the article What is a Covered Call Option Trade? in Options Investing is owned by James Brumley. Permission to republish What is a Covered Call Option Trade? in print or online must be granted by the author in writing.