To learn more, watch OIC’s short video The covered call
Turning from protection to yield enhancement on an existing stock, let’s look at the covered call strategy.
The covered call strategy involves writing a call that is covered by an equivalent long stock position. The income received from the call option sold provides a small hedge on the stock and allows an investor to earn premium income, in return for temporarily surrendering some of the stock's upside potential.
A covered call writer is often looking for a steady or slightly rising stock price for at least the term of the option. If you’re feeling very bearish or bullish, this may not be the strategy for you. Learn more about the covered call strategy and other strategies with The Options Industry Council’s Quick Guide.
The covered call can be a good way to enhance the return on a stock already held during sideways or rangebound market conditions. It is typically not suitable for markets experiencing dramatic up or down moves.
One way to look at the covered call is to see the premium received not only as extra income, but also as a buffer should the position not turn out as expected. For this strategy, the risk is in the stock. If the stock declines sharply, the investor will be holding a stock that has fallen in value, with the premium received reducing the loss. If the stock moves sharply higher, then the investor will be unable to participate in any upward move beyond the strike price of the call option sold, although he will also have received the premium income from writing the call.
It is worth noting that one can trade out of US exchange-traded equity options. For example, if the market rises sharply, then the investor can buy back the call sold (probably at a loss), thus allowing his stock to participate fully in any upward move. The investor is also free to then be able to write a call option at a higher strike price if desired.