What are Covered Calls?

Done correctly, stock market investing can provide an excellent return on capital. One should, however, beware of arcane strategies, the promoters of which claim may yield outrageous returns far beyond what any conservative investor should expect. That said, covered calls are one of the more conservative strategies, and holds less risk than other options or derivatives mechanisms.

In a straightforward stock transaction, you buy low, and wait for what you feel is the highest possible price at which to sell. In a covered call however, you agree ahead of time to sell shares at an agreed-upon price, called the strike price. On the other end of the transaction, another investor purchases an option, which is the right to buy your stock that that strike price. The seller of the covered call option earns a premium, which is paid by the option purchaser.

The advantage to the covered call investor is that even if the stock does not reach the strike price and the options buyer does not exercise the option, the premium is still earned. The investor's stock holdings are earning money even when the price is stable or decreasing, so long as there are options buyers who wish to purchase options on the stock.

The options buyer also gains a potential advantage; they gain the right to purchase a stock at a pre-set price. If the stock price rises beyond that point, they can exercise their option and gain an immediate profit. For example, suppose a stock is trading at $10 and the strike price is $12; let's assume that the stock price suddenly surges to $20. The options buyer exercises the option to purchase the stock at $12, and immediately turns it around and sells it for $20.

The obvious drawback to this strategy is that the covered call writer loses the profits that would have come from selling the stock at the true price of $20, and instead has to sell it at $12. However, this is mitigated by the fact that over the long run, the covered call writer has earned profits while the stock was not rising in price, by selling options that were not exercised. When the options buyer does not exercise the option, the covered call writer still gets to keep the premium.

The premiums may reach 10 percent of the stock's value or more for a one-month contract. Premiums are higher for more volatile stocks. This raises the the second disadvantage of covered call writing. The best premiums are gained from stocks that are the most volatile, which means that if the price of the stock drops significantly, there will be less demand for options - the covered call investor may lose money. As such, it is important when using this strategy to conduct due diligence on each stock, research its fundamentals and make investments only on risks that are acceptable to you.