In the world of options, there seem to be as many investment strategies as there are stocks. Interestingly, the underlying value of an option is often tied to an investment, such as a stock. However, options are actually only contracts that grant the owner the right, without the actual obligation, to buy or sell 100 shares of stock at the strike price by the expiration date of the option. The two most popular types of options are “call” and “put” options.
A call option is a contract that gives an investor the right, but not the obligation, to buy 100 shares of the underlying stock. If you own a call option, then you are known as the “holder.” If you sell a call option, then you are the “writer.” A call option assumes that the value of the underlying stock will rise to at least the strike price by the expiration date (put options are the opposite, and expect the value to decrease). Holders of call options must pay a premium when purchasing the investment. The writers of call options, on the other hand, will receive that premium – whether or not the holder ever decides to exercise the option or not. If the writer of the call option actually owns the underlying stock, then it is known as a “covered call.” When the writer does not own the underlying stock on the option, it is referred to as a “naked call.”
Though the sell-covered call strategy works best when stock prices remain steady, investors should research the underlying stock to gauge the direction of stock prices. If you are only slightly convinced that prices will remain the same, protect the sell-covered call tactic by selling options at lower strike prices. Since lower strike prices are less of an investment risk for the buyer of the option, they will command higher premiums. However, if you believe that stock prices may also rise (but not actually reach the strike price), sell options at higher strike prices. Of course, if the stock price falls, you will pocket the premium as the option will go unexercised.
Writing a covered call is about minimizing risk and maximizing profits. The investor typically doesn’t really know if the price will go a little up or a little down – just that there will be some fluctuation in the near future. In the “sell covered calls” option strategy, the investor is certain that the price of the stock will not decrease (because if the investor is certain the price will decrease then the better option is to outright sell the stock instead). Therefore, he/she will be writing “covered call” options and making a profit from the premiums paid by other investors. If an investor is not entirely convinced that prices will not drop, then he/she should sell at a lower strike price. This will increase the premium amount that can be charged for writing the option as it is less risky for people to purchase an option with a lower strike price.
Loss is limited using the “sell covered call” option strategy because the writer actually owns the underlying stock. Loss equals the difference between the market price and the strike price (market price will be higher than the strike price) but is offset to an extent by the premium received when selling the option. The potential for profit using this strategy comes in if the market value of the stock does not rise at all and the options goes unexercised and the premium is pocketed or if the market value rises above what was paid to purchase the stock but doesn’t rise all the way to the strike price (in this case after the option expires, the stock can be sold at a higher price in the open market and the profit from this sale plus the premium received from writing the option will be the total profit from the strategy).