A covered call is an investment strategy combining ownership of a stock with a short options position in the same stock. It is also called a buy-write position, since the investor buys the stock and writes, or sells, a call option on the stock. A covered call position will outperform the performance of the stock alone if the stock price remains the same or goes down; however, if the stock price goes up significantly, a covered call position will under-perform versus the stock alone.
Covered calls provide the investor with an additional source of income above the fluctuations in stock price and any dividend distributions. This additional income comes from the premium received when the call option is sold. Assuming you sell an out-of-the-money call option, your covered call position will outperform the stock alone if the stock trades flat or lower over the life of the option. However, even if the stock trades higher, your covered call position won’t lose money; your upside potential has been just been limited to the strike price of the call option you sold.
The top ten reasons to establish covered call positions are:
1) You believe the long-term prospects of the stock are good, but short- to mid-term you believe the stock will trade slightly lower.
2) You believe the long-term prospects of the stock are good, but short- to mid-term you believe the stock will trade flat.
3) You are a long-term, diversified investor, but you are bearish about the near-term overall market performance and you want to increase your near-term returns.
4) You really like a particular stock, but you foresee a rough spot in the near future; you want to hold the stock for the long run, but want to ease the pain of a short-term downturn.
5) You are new to options trading, and would like to try a lower-risk strategy to get your feet wet.
6) You want to make money in all market conditions, even downturns in the market.
7) Your portfolio’s returns are anticipated to be lower than you’d like in the near future.
8) You would like to create an investment with a risk profile greater than that offered by bonds, but less risky than outright stock ownership.
9) You want to leverage your long-term investments to increase short-term returns.
10) You want to increase returns from a stock that has been and is expected to continue trading in a defined price range.
Overall, covered calls are a great way to generate increased earnings from under-performing long-term investments. Covered calls do not eliminate all of the downside risk of owning a stock; therefore, if you are seriously concerned about the long-term value of a stock you own, you should look to another more vigorous hedging strategy. However, covered calls are a great way to maximize short term investment returns in a slightly bearish or uncertain environment.