The covered call is a strategy in options trading whereby call options are sold against a holding of the underlying common stock.
Using the covered call option strategy, the investor gets to earn a premium writing calls while at the same time appreciate all benefits of underlying stock ownership, such as dividends and voting rights, unless he is assigned an exercise notice on the written call and is obligated to sell his shares.
Once a covered writer sells a call option, he creates a range of profitability. If the underlying security stays within this range until the option expires his investment performance will be superior to an investor who just held the underlying security without the covered write. While covered writing does not completely eliminate the risk of holding a stock, the strategy provides a cushion against price declines. It is important to remember that the strategy will out-perform outright stock ownership if the stock falls slightly, remains the same, or rises slightly.
Any time the market price of the underlying security exceeds the exercise price, the likelihood that the option will be exercised and the security will be taken or “called” from the writer increases as well. However, the writer is not bound to hold the position until the option expires. All the writer needs to do is repurchase the option he has written. The repurchase price may be more or less than the price originally received (and therefore may result in a profit or loss), but the obligation to deliver the underlying security is then terminated. The ability to repurchase the option can be effected any time prior to the receipt of an exercise notice.
Westbourne believes that the covered call strategy is a good way of increasing cash flow, and at the same time, providing a hedge to some degree against price declines. However, the profit potential of the covered call writing is limited as the investor had, in return for the premium, giving up the chance to fully profit from a substantial rise in the price of the underlying asset.
As always, consult an investment professional before buying or selling options. Never invest in something you don’t understand. Be sure to always read an investment’s prospectus or disclosure statement carefully. If you can’t understand the investment and how it will help you make money, ask a trusted financial professional for help. If you are still confused, you should think twice about investing.
Prior to buying or selling an option, investors must read a copy of the Characteristics & Risks of Standardized Options, also known as the options disclosure document (ODD). It explains the characteristics and risks of exchange traded options. A copy of this document and supplements can be found here.