The buyer of a call option has the right to buy the underlying security at the strike price before the expiration date. The option seller, or writer, is granting the call buyer that right and must deliver the underlying security if the call option is exercised by the buyer.
If the option writer already owns the underlying security when the call trade is opened, then the call is said to be covered. That means the options writer has covered their position in the options contract with a long position in the underlying security.
If a trader owns 100 shares of Apple (Nasdaq: AAPL), then they could write one covered call contract against those shares. If Apple rises above the strike price before the exercise date, then the buyer could exercise the option and the shares would be sold from the option writer's account at the strike price. The covered call position would lead to a small premium collected and a sale of Apple at a price the writer agreed to accept.
How Traders Use It
Covered call writing is usually considered to be a low-risk, income generating strategy. Traders who own a stock can sell deep out-of-the-money calls to receive small premiums while they continue to benefit from appreciation in the underlying security.
For example, a trader owning 100 shares of Apple could sell a call with a strike price that is $50 more than the current market price and expires in 30 days. They would immediately receive a small premium of maybe $5 a share.
If Apple goes up by less than $50 or falls during the next 30 days, selling a covered call increases the trader's profits by an additional $5 per share. If this strategy is repeated over time, then it can deliver a significant amount of income to the trader. If Apple rises, then the trader will be able to sell at a profit.
Some traders will sell a security by using a covered call to get a slightly higher price on the transaction if the call is overvalued relative to the underlying. If the trader with 100 shares of Apple wanted to sell at the market and an at-the-money call was selling for $5 on the expiration date, then they could sell the call and make an additional small profit on the trade when the call is exercised.
These opportunities are rare, but they are possible in fast-moving markets where volatility is relatively overpriced. Volatility is a critical factor in determining the options price, and if the level of volatility changes abruptly, then market opportunities like this can exist for brief periods.
Why It Matters To Traders
Covered call writing can allow a trader to increase their income and limit the risk in some trades. This strategy is often used with stocks that pay a dividend to generate additional income.
Action to Take --> In addition to the dividend, the trader could generate returns of several percentage points on the covered calls, and if the stock appreciates, then the trader gains from that as well. If the strike price is greater than their initial purchase price, then the trader will be able to sell their position with a gain and reinvest the profits into another covered call position. By repeating this process over time, large profits are possible.
This article originally appeared on ProfitableTrading.com:
Covered Calls: A Simple Way to Generate Income on the Stocks You Own