The covered call strategy is a very popular strategy among investors, particularly among the ones who traditionally have owned a lot of stock. Although there are certainly advantages in writing covered calls, it is very important to clearly understand the inherent risks before embarking on a premium writing campaign. In this article we will review the covered call strategy and delineate the key risk and reward characteristics involved with this type of option position.

Covered call investing isn't much different than simply buying and selling stocks, which most people are already familiar with and doing. Option premium is the key advantage and the strength of covered call writing. If the underlying equity is purchased simultaneously with writing the call contract, the strategy is commonly referred to as a buy-write.

However, if the shares are already held from a previous purchase, it is commonly referred to as an overwrite. In either case, the stock is generally held in the same brokerage account from which the investor writes the call, and fully collateralizes, or covers, the obligation conveyed by writing a call option contract. Covered calls are a way to earn additional income on your stock portfolio.

The covered call can be utilized in any market condition; it is most often employed when the investor, while bullish on the underlying stock, feels that its market value will experience little range over the lifetime of the call contract. While this strategy can offer limited protection from a decline in price of the underlying stock and limited profit participation with an increase in stock price, it generates income because the investor keeps the premium received from writing the call.

In addition, the investor receives all the benefits of underlying stock ownership, such as dividends and voting rights, unless he or she is assigned an exercise notice on the written call and is obligated to sell their shares. Maximum profit will occur if the price of the underlying stock you own is at or above the call option's strike price, either at its expiration or when you might be assigned an exercise notice for the call before it expires.

When using covered calls it is very important to understand where the risk in this type of position resides. This risk can become substantial if the stock price plummets in price as the written call expires.  In this situation, traders cannot sell the stock; they are locked in until expiration date because by writing a covered call traders have the obligation to sell their stock at a set price until the expiration date. In this particular case traders buy back the call, which ends their obligation and frees up the stock to be sold.

Another possibility that must be taken into account if writing covered calls is that a stock might really start to rally unexpectedly. In this case, traders experience an opportunity loss in that after the stock has exceeded the strike price used plus the premium received, and they no longer gets to participate in the upward movement of the stock, which is why it is referred to as an opportunity loss. Essentiality, by using a covered call, the upside profits are capped. Keep all these points in mind before embarking on a covered call writing campaign.

Happy Trading.

Jeff Neal 
Senior Writer, Options Strategist & Profit Strategies Radio Show Market Correspondent
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