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Covered Call Writing Introduced

May 15, 2002

Selling options usually involves a greater risk than buying options, but the exception to that rule occurs with covered call writing.

If you sell a call option, you are selling someone else the right to purchase your stock for a specified price (strike price) any time before the option expires. If you own 100 (or more) shares, you have the stock to deliver, in the event the owner of the call option wants to exercise his rights and buy your stock, then you are covered. This protects you from the greatest risk of selling a call option: you do not have to be concerned if the stock rises in price, because you can simply deliver the stock you own and do not have to go to the marketplace to buy stock to deliver to the option exerciser.

If you own stock, you make money when it goes up in price and you lose money when it declines in price. That is a simple concept, and the basis for most investments. By selling a covered call option, you hedge your investment. A hedge is a position that partially offsets an existing position, resulting in a combined position that has a reduced risk of loss. In the case of a covered call, the initial position is long (ownership of) the stock. By selling a call option, you hedge your position because:

Your risk of loss (if the stock declines in price) is reduced since you receive cash for selling the call

Your maximum profit is reduced because the call option limits the price you can get for   selling your stock

Why would you want to sell a covered call option?

1)   If you are concerned your stock may decline in price over the coming several months, but still want to retain ownership of the stock, selling a call option provides cash income and protection in case the stock does go down in price

2)   You are satisfied with your stock, but are concerned the stock market may be vulnerable to a decline. Selling a call option provides a limited amount of insurance in case your fear comes true

3)   Your stock has not been making any money for a period of time and you want the investment to generate some income. Selling a call option provides cash now

4)   You believe your stock is a good long-term investment, but that it will not rise significantly in the next 6 months

5)   You are attempting to sell your stock and want a higher price than is currently available

6)   You are making a new investment in a stock and want to buy the stock for a lower price than is currently available

These are some of the reasons for selling a covered call option. These strategies all provide the profit potential or loss reduction sought, but there are risks associated with the strategy. We will look at each of the above reasons for selling a call option and the risk associated with them next time.

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