Posted on September 7th, 2011 
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Covered calls refers to a low risk options strategy involving an investor owning call options as well as the asset underlying the options. It is probably the lowest risk options strategy that can be devised. The primary purpose is to generate income. The income is generated by selling the call option.
Selling call options opens up an investor to the risk of the options being exercised requiring the investor to supply the underlying shares. Under a covered call strategy, the investor already owns the underlying shares largely avoiding any negative consequences from this risk. The share ownership covers, or offsets the risk of, the call options.
Under the strategy the investor, by definition, holds a long position in both options and the underlying asset. If the price of the asset rises so that the owner of the options exercises the option and makes a call on the asset, the investor already owns the asset and simply transfers that ownership to the option owner. The investor receives the appreciated price for that asset. Naturally, the investor benefits to the extent that the price of the asset has appreciated.
The strategy is also known as a Buy Write strategy. The investor buys the underlying asset and then writes (or sells) the call options. The strategy is used when the investor has a short term neutral to negative view on the asset and for this reason hold the asset long and simultaneously holds a short call option position.
An example may help illustrate the strategy. An investor buys one hundred shares in AAA Company at one hundred dollars per share. The investor expects the price of these shares to remain flat or maybe even fall over the next few months.
Following the share purchase, our investor also sells ten thousand call options on XYZ shares at thirty cents for each option. The call options have a six dollar strike price and a two month expiry. This call option sale generates a three thousand dollar income for our investor.
Three outcomes are possible regarding the XYZ share price over the next two months. Firstly, it will stay constant within a band of five to six dollars. Secondly, it will decrease below five dollars. Thirdly, it will increase above six dollars.
In the first two scenarios, the share options expire worthless without their owner making a call on the shares. In both these cases, our investor continues to own the XYZ shares as well as generating a three thousand dollar income from the option sale.
In the third scenario, exercise of the call options is triggered. The investor is obligated to sell one hundred AAA shares. Total income from the share sale is ten thousand dollars. The investor also retains the one hundred option sale income.
In summary, covered calls offer a low risk strategy to generate additional income from share ownership. Selling (writing) call options does place a cap on the potential share price upside an investor can gain through share price appreciation. However, this is not a major consideration since the cap can be managed by the investor by choosing an option series with an appropriate strike price.
Source: Tim Leary
