Covered Calls
A chapter from our Advanced Homestudy Program

Covered-call writing is a strategy for those looking to hedge their stock positions over the short term. Many covered-call strategists use this tool to generate cash when they envision shares of the company that they own stagnating over the short term. At the same time, they feel there is little downside risk in the near future.

Simply stated, covered-call writing involves selling one call option for every 100 shares of stock that you own. The writer of the call options receives income from the buyer in the form of an option premium. In exchange for the premium received, the seller of the call takes on the obligation to deliver the shares to the call buyer at a predetermined price (strike price) in the event the shares are called away from the call seller.

Covered calls can accomplish two purposes. The desire to lower one’s risk is generally the primary objective of the strategy. In effect, selling a covered call reduces the ultimate cost of maintaining an equity in one’s portfolio. For example, selling a six-month at-the-money call option for 10 on a stock trading at 100 reduces the stock’s effective cost by 10 points to 90, and thus cushions the negative impact of a decline in the share price.

The second objective is to efficiently capture an option’s time premium - the price of an option less its intrinsic value. (Intrinsic value for a call option is the amount by which the current stock price exceeds the call’s strike price). An at-the-money or out-of-the-money option consists entirely of time premium.

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