Covered Call

Selling calls against a long stock position (a.k.a. a Covered Call) is an increasingly popular way for conservative investors to help generate additional income in their portfolios. An investor with a short-term neutral opinion of the underlying stock he or she is holding is the more likely to utilize the covered call strategy.

A Covered Call Example

An investor owns shares of XYZ Corp. and thinks it has a good long-term outlook despite a relatively flat near-term prospectus. Believing that XYZ will likely trade within a dollar or two range of its current $40 share price, the investor enters a covered call strategy by selling an XYZ call option for $42 and earning the premium.

How XYZ shares trade during the life of the option will ultimately determine the success or failure of this covered call:

Flat (below the $42 strike price) - the option expires worthless and the investor keeps the premium. In this case, the covered call has allowed this investor to essentially outperform the stock.

Drop - the investor's option expires worthless and he or she keeps the premium. In this situation, the investor has once again outperformed the stock by gaining the premium generated by the covered call.

Rise Above $42 - the option is exercised and the investor's upside is capped at $42, plus the option premium. In this case, if the stock price goes higher than $42, plus the premium, the covered call strategy has underperformed the XYZ shares.

Using Near Month Options

When writing a covered call, most investors tend to sell the near month option, meaning the options will expire in the next month.. For one thing, the earlier the expiration, the less opportunity the stock has to trade through the strike price. Equally important, however, is the role that time decay plays in the value of the options. Like all out-of-the-money options, the covered call in the example above has no intrinsic value. As such, the only value is the time premium or time value which, in the final month before expiration, decays more and more rapidly. For these reasons, investors often sell options that have one month remaining until expiration when employing a covered call.

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