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The covered call is often the first type of strategy an options trader attempts because they usually come from a stock-investing environment. The covered call is a way to generate income from the portfolio, and it can also be used to lock in some profits. It is important for the trader to understand the mechanics of the covered call before being able to consistently profit from this approach.

Basically, a covered call is a strategy where the option strategist buys stock in increments of 100 shares, and for every 100 shares sells a call option contract against it. When the trader sells the call, he or she is giving somebody else the right to buy the stock at a fixed price. The word covered comes from the fact that the seller of the calls is not at risk if the stock climbs higher, as opposed to someone who sells uncovered or naked calls and can lose an unlimited amount if the stock moves higher. With covered call writing this upside risk is eliminated because you will always be able to deliver the shares, no matter how high the stock climbs.

It is important to note that there are some risks in the covered call strategy. The position only covers you if the stock climbs through the strike price you sold the call at but it does not protect you from the losses incurred from a large drop in the underlying stock price. The covered call lowers the cost basis of the stock just by the amount of premium received. Any drop below that new cost basis would show up as losses to the position.

Covered call writers usually fall into two different camps with two distinctly different objectives. One such type is the strategist who wants use the strategy to generate income against stock they plan to hold regardless. The other type of covered call writer employs the strategy for the sole objective of receiving high premiums.

This income seeking approach allows the investor to receive a little downside hedge and then getting paid to sell the stock at a price they see favorable. Assuming it is a fundamentally solid stock, the investor would be more willing to assume more downside risk. In essence, the investor would hold the stock whether options were available or not.

Now, the approach that just seeks out high premiums has several pitfalls and can be very dangerous. Usually, traders who are making their selections based only on high premiums do not truly appreciate or understand the downside risk of the covered call strategy. Many times, when they are selecting based just on high premium, they do no further investigation on the quality of the stock—or, for that matter, do not even know what the company really does. In addition, the issues that have these high premiums are often very speculative stocks that are vulnerable to large price declines if things do not go exactly right.

It is far better and effective if the investor concentrates on the quality of stock first before looking at premiums. If you select fundamentally superior stocks that you would want to own for at least the intermediate term, then writing covered calls can be a very profitable strategy that lowers the cost basis of the stock. However, if you’re just seeking premium and ignore the inherent strength or weakness of the stock, then you may have to endure some market disasters with devastating impacts to your account equity.


Jeff Neal 
Senior Writer, Options Strategist & Profit Strategies Radio Show Market Correspondent
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Listen to Jeff at www.ProfitStrategiesRadio.com

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