What is a covered call?

A covered call is an income-producing strategy where you sell or write call options against shares of stock you already own. Typically, you’ll sell one contract for every 100 shares of stock. In exchange for selling the call options, you collect an option premium.

But that premium comes with an obligation. If the call option you sold is exercised by the buyer, you may be obligated to deliver your shares of the underlying stock. Fortunately, you already own the underlying stock, so your potential obligation is covered _ hence this strategy’s name, covered call writing.

Remember, like all strategies, covered calls are subject to transaction costs. This strategy involves two trades and therefore has two commissions: one to purchase the stock and one to sell the call.

 

Why write covered calls?

When you sell covered calls, you’re usually hoping to keep your shares of the underlying stock while generating extra income via the option premium. You’ll want the stock price to remain below your strike price, so the option buyer won’t be motivated to exercise the option and grab your shares away from you. That way, the options will expire worthless, you’ll keep the entire option premium at expiration and you’ll also keep your shares of the underlying stock.

If your stock’s price is neutral or dropping a bit, but you still want to hold onto the shares longer-term, writing covered calls can be a good way to earn extra income on your long position. But remember, you’re also a stockholder, so you’ll most likely want the value of your shares to increase _ just not enough to hit your covered call’s strike price. Then you won’t just keep the premium from the options sale, you’ll also benefit from the shares’ rise in value.

 

What happens if the stock shoots through the roof?

What happens if you write a covered call – and then your underlying stock shoots skyward, exceeding the option’s strike price? In this case, the option buyer has reason to exercise his or her call option because buying the stock for the strike price is cheaper than buying the stock in the open market. This is called being in-the-money. In this scenario your shares will mostly likely be called away from you. You might be sad to part with your stock and miss out on some of those gains – but the scenario holds some benefits for you.

Learn More About Ally Invest

Tips for Writing Successful Covered Calls (Part 2)