When an investor uses covered call options, the investor sells a call option while owning the stock that is the underlying security of the call options. The stock that is securing the call option may be held by the broker handling the call options.
Using this strategy, the investor sells a call option for the same number of shares that the investor owns. A covered call is a fairly common options trading strategy.
The covered call option may be called an overwrite if the investor already owned the underlying stock at the time the investor sells the call options. A covered call option is sometimes referred to as a buy-write if the investor sells the call options and purchases the underlying stock at the same time.
By selling the call option, the investor is giving the buyer the right to purchase the stocks at the strike price of the option. The writer of a covered call trade often is expecting that the stock will not reach the strike price.
If the underlying stocks don’t reach the strike price, the call options the investor sold would expire worthless. The investor would then keep the option premiums as a profit. Any gain in the value of the underlying stock that is still below the strike price could also be considered part of the seller’s profit.
If the underlying stock reaches the strike price, the buyer has the right to exercise the option. If the buyer exercises the option, the seller must sell the stock shares to the buyer for the strike price. If the stock price increases drastically, the seller of the call has lost money that the seller could have made by selling the stock on the market.
The buyer of the call option makes a profit if the stock price rises above the strike price. The buyer can buy the stock at the strike price which would be less than the market price and sell the stock to get the profit from the trade.
The buyer’s risk is limited to the premium paid for the call option. Buying a call option is a common practice for a beginning options investor. While buying a call option has the risk of losing the option premium paid, the potential profit is theoretically unlimited if the stock rallies and makes a major upwards move.
Selling a call option is more risky than buying one because the potential loss for selling a call can be substantial if the stock rallies and the seller is forced to sell the stock at the strike price. The potential loss of a covered call option would be the difference between the strike price and the higher stock market price for the stock minus the option premiums received for the call options.
Source: John Mylant