Covered Call Option

A covered call option is when the owner of stock writes an options contract obligating him or her to sell stock at the contract price, the strike price, at a future date, the expiration date, if the buyer so chooses. The buyer of a call option pays a premium to have the option but not the obligation to buy stock in blocks of 100 shares per contract. The seller of a covered call option, or uncovered call option, is obligated to sell if the buyer exercises the contract. This sort of occasional options trading is fairly free of risk and profitable. An uncovered call option means that the writer or seller of the option does not own the stock in question and can, potentially result in losses.

Of the various kinds of options trading, options traders engage in covered call options when they believe that their stock price will not go up. A common example is when a long term investor owns a cyclical stock that pays good dividends. The long term investor does not intend to sell the stock and believes that the stock is now trading at the top of its trading range. He or she will sell call options for 100 shares per contract expecting the premium paid on the option to cover part or all of the decrease in stock price as the stock cycles back down.

In this case the buyer of the call option believes that the stock will keep going up, will break out of it trading zone, or is subject to some piece of good news that will make the price go up substantially. Rather than paying for the stock the call option buyer will pay a premium, per contract, for the option to cash in on, what he or she believes will be, a healthy jump on the price of the underlying stock.

Both traders in this type of options trading transaction believe that they are engaging in risk management in options trading. The buyer of the call option does not want to buy the stock for fear that it will go down in value but is willing to risk the premium necessary to buy the option to lock in the option of buying if it goes up. The seller of the option is set to make a little profit as the stock cycles back down but is covering the risk of upward movement. If the stock goes up and the buyer exercises the option the seller still keeps the premium. Writing a covered call option is fairly safe in that the only risk is that the seller may miss out on a run up in stock price. He or she will not lose money on the options transaction and will cover part of the loss of the stock going down. This can be a profitable long options strategy over the years.

This is in contrast to selling an uncovered call option. In this case the seller does not own the stock, will profit from the premium if the stock price goes down but will need to come up with the money to buy stock and sell as the contract requires. Then he or she must take the sale proceeds (at the lower strike price) to pay back part of the cost of buying stock at the higher price and live with the loss.

A covered call option is a relatively risk free way for stock owners to profit from their stock. Doing a call option uncovered can be a nice way to make money with no investment and it can result in substantial losses if the stock price goes up.