Covered call writing is a very commonly used strategy.  For good reason.  Most of the time it is profitable to adopt this strategy, and over the longer term, it provides superior returns with less overall risk.  That's a great combination and is a wonderful strategy for learning how to use options.

The negative feature of this method is that it affords minimal protection against a market collapse, and money is lost when the markets tumble.  True, the covered call writer loses less than the stockholder - but for most investors, that is not a big consolation.

Definition

'Write' is the same as 'sell'

A covered call is a hedged option  position where calls are sold against a long position in the underlying instrument. In essence, the trader is limiting profit on the long position in exchange for receiving the option premium. One call option is sold for each 100 shares owned.

Example:

Buy or own 400 shares of General Electric, GE
Sell any 4 call options; perhaps 4 GE Sep 16 calls

Each option gives the buyer the right to buy 100 shares of GE @ $16.00 per share at any time before the option expires (after the close of business on the 3rd Friday of September).

Why would a stockholder do this?  Why limit profits?

• Stocks do not always rise

• By selling this call, you receive ~$53 per contract [That's $0.53 per share]

• You get that cash now and it is your to keep, no matter what else happens

• In this example, that $53 represents a return of more than 3%

• Not bad for two months

• Plus you get to keep the dividends

• Plus, if the stock dips you earned $0.53 that cushions any loss - when other stockholders earned nothing

• You get those advantages in return for sacrificing any profits above $16 per share

• If the stock is above $16 at expiration, the option owner will take your shares and pay $16 per

• This is the obligation you must accept in return for the advantages received

It's a trade-off.  You get some nice benefits, but no one buys that option just to give money to you.  That's why there is an obligation to sell shares.  Is this a good strategy for you?

to be continued...

Mark D Wolfinger

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