Covered Calls for Dummies
What is a covered call and why are they so
A covered call is when you buy shares of a stock and write (sell) call
options against the stock for income. Alternatively, you may already own shares of a stock and choose to
write calls against them, again for income.
The price you receive is the “option premium” and that
goes into your account immediately: spendable CASH! When the call option expires, either you sell the
underlying stock and keep the premium, or you keep the stock and write more options for the next
You can do this over and over and over.
Why are they called “covered
When you write (sell) an option at a certain strike price, you are
contractually obligated to deliver that stock to someone at option expiration. It’s “covered” because you
already own the underlying stock. Perhaps the riskiest option is called a naked call; in the above example
you write (sell) a call at say $35 without buying the underlying stock (many brokerages will not allow just
anyone to do this by the way). If the stock goes to $100, you are on the hook now to buy it at the $100 and
deliver it to the buyer. There is unlimited risk.
Why is being an option seller statistically more profitable than
being an option buyer?
First, writing (selling) produces immediate
income. The Options Clearing Council (OCC) estimates that only 10% of all options contracts are
exercised; leaving 90% never being exercised. Even if that math is off a little, selling options and having
them expire worthless (a good thing for the seller) has an astronomically higher
Who writes covered calls?
For this reason, large institutional money managers, pension funds, mutual
fund, hedge funds, just about any institution that holds a large amount of stock, writes covered calls with
married puts to
increase their returns.
I heard one fund manager in an interview once say he would be crazy to hold
“naked stock!” It took a minute to sink in that he was talking about owning a stock, WITHOUT selling covered
calls! He was “naked” because without the covered call, the only way he could make money was to have the
stock go up! If you ever wondered why these funds make huge returns while everyone else hopes for 10% a year,
this is one reason.
For more insight and a good laugh; check out our latest article
"Covered Call Writing
Irony." It gets right to the core of why write covered calls.