What is a covered call?

Answer 1

Covered CallsA covered call is an options strategy in which the holder of a long position sells call option contracts on the underlying securites.

How it works:

Lets say you are the holder of 200 shares of AT&T. You enjoy the dividend that it pays and believe it is a good investment to hold onto long term even though you may not expect a large move in the share price in the immediate future. A covered call option strategy may be a great way to increase your return on this position.

For this example lets say that AT&T is trading at $35 and a December call contract with a strike price of $39 is trading for $1.00 per share.

As the owner of the underlying security you could write/sell 2 contracts (100 shares a piece) for the December calls that are trading at $1.00 per share. As the contract writer you would immediately receive the $1.00 a share x 200 shares or $200.

Now, lets look at what you are obligated to do for this $100 premium. The person that bought this contract from you now owns the right to exercise that contract and buy your shares for $39 dollars anytime between now and the December options expiration date.

So, there are 2 scenarios that could take place:

1. You pocket the premium and the option is never exercised.
2. You pocket the premium and the contract is exercised and your shares are sold at $39 dollars regardless of what the market price is at the time. In effect, limiting the upside potential on your shares between contract origination and December options expiration.

There is a tutorial on covered calls here: http://www.borntosell.com/covered-call-tutorial

Answer 2

One benefit of covered calls is the writer of the stock get the premium from the writing of the covered call during the transaction. Also the premium can offset a fall of the stock price. There is little or no money lost to the writer. It's all about stability.