When you write a covered call you are allowing someone to buy shares you currently own at that specific price before the option contract expires. This is a great method for generating income into your account using stocks you already own.
For the stock to get called away, the price needs to be at or above the strike price you selected at expiration.
If the stock does get called away, that’s okay because you were comfortable with that possibility at the strike price you selected. If it doesn’t get called away, then the contract expires worthless.
What happens if it expires worthless, you might ask yourself?
This means you get paid the premium and you keep the stock. Now you can turn around and write another covered call to make even more money. You can do this an infinite number of times on the same stock as long as it doesn’t get called away.
One reason selling covered calls is a great strategy is that you already own the stock that you are writing the call for, which is why it’s called a “covered call.” The only risk you take is possibly losing the stock.
However, this isn’t really a risk because you have done your homework and you know that if this particular stock gets called away at your strike price then you will just take your profits and move on.
In either situation, you make money.
First, you get a premium for selling the covered call. Second, if it gets called away from you at that higher strike price that you selected you gain the difference between the price at which you own the stock and the higher price at which it got called away — instant profit.
Selling covered calls is a great method for people who are new to options trading because it allows them to generate cash income while not really taking on any substantial risk.
However, no matter how experienced a trader you are, this method works for everyone. So how does a covered call work? Let’s break it down.
Writing a covered call, step by step
When it comes to options, you have two sides: calls and puts. If you are selling a call, you have the obligation to sell at a specific strike price. If you are selling a put, you have the right to buy at a specific strike price.
In order to sell a covered call, you must first own at least one contract of that stock, which is equal to 100 shares. Every option contract is equal to 100 shares of that particular stock.
For example, if you wanted to own one option of eBay (EBAY) at a strike price of $56, then you would have to have at least $5,600 in your account to be able to cover that contract — if it was put to you at expiration.
To sell a covered call you need first to decide which stock in your portfolio that you have at least 100 shares of that you would feel comfortable with letting go of if it got called away.
You wouldn’t pick a stock that you extremely bullish on since there is a chance someone will call it away from you.
Then, pull up the options chart for that stock and decide what strike price you want. Typically, you want this to be out-of-the-money (OTM) because you always want the stock to be going up in price if it gets called away. This means bigger profits for you.
Next, select the expiration date that the contract will be good through. Typically, the further out you go the higher the premium (instant money in your pocket), but it also means there is more time for volatility. This makes it harder to predict what might happen.
Once you have those two selected — strike price and expiration date — you place the order.