What it is:
How it works/Example:
For example, assume that on January 1, Charlie owns 100 shares of IBM stock. IBM currently trades at $100, but Charlie is pretty sure it will stay below $105 for the near future.
To generate a little bit of extra income, he sells Jenny a call option with a February expiration date and a strike price of $105. The call option is priced at $3 per share and it controls 100 shares. By selling the call option, Charlie receives a $300 premium today in exchange for the possibility that he will have to sell IBM stock to Jenny for $105 between now and the February expiration date. By buying Charlie's call option for $300, Jenny has the right (but not the obligation) to buy 100 shares of IBM from Charlie at $105.
Now consider the following scenarios:
IBM trades at $103 at expiration. Jenny's option expires "out of the money" and is worth zero. She lost $300 on her trade.
Charlie gets to keep the $300 premium, plus his shares are now worth $300 more than they were worth on January 1. Charlie made $300 in cash and records a $300 paper profit.
IBM trades at $110 at expiration. Jenny's option is "in the money" and Charlie is obligated to sell her 100 shares for $105 per share, even though the stock trades at $110. Because she gets the shares from Charlie for $105 and can turn around and sell them for $110, Jenny's trade generated $500 minus the $300 she paid for the option, for a total gain of $200.
Now let's look at the trade from Charlie's perspective. Charlie's 100 shares just went up to $110 from $100, for a $1,000 gain. But because he owes Jenny 100 shares of stock and has to sell them to her for only $105, he loses $500 on that leg of the trade.
So Charlie's trade looks like this: gain of $1,000 less $500 (because he must buy 100 shares of stock at $110 and sell at $105) plus the $300 premium = $800.
As you can see, by selling a covered call, Charlie has limited his upside potential in exchange for receiving the $3 option premium up front. The $1,000 gain from the increase in the value of the stock is split between Charlie ($800) and Jenny ($200) via the call option.
To illustrate the point that his upside potential is limited, let's assume that IBM traded at $115 at expiration and Charlie's trade looks like this: gain of $1,500 less $1,000 (because he must buy shares at $115 and sell them for $105) plus the $300 premium = $800.
IBM trades at $95 at expiration. In this scenario, Jenny's option expires "out of the money" and is worth zero. She loses $300 on her trade.
Charlie's stock holdings lost $500 in value, but the loss is buffered by the $300 premium he received for writing the call. If he has no intention of selling his shares and locking in the loss, he still gets to keep the $300 premium while he waits for the IBM stock to bounce back. To protect his holdings from future declines, he could buy a protective put option [click here for an article on How to Use Protective Puts to Limit Losses].
Why it matters:
The safest way to sell an option is to write a covered call. The strategy is so safe, in fact, that it is suitable for most retirement (IRA) accounts. In this type of trade, the investor sells a call option on an underlying stock that he/she already owns. A call option written against stock you don't own is called a naked call.
In the long run, because options tend to lose their value as they approach their , selling options tends to be much more profitable than buying options. In particular, the covered call strategy works best when the investor plans on holding the underlying stock for a long period but does not expect a significant increase in the near term. The investor limits his/her upside potential in return for a guaranteed premium. [Click here to learn more about this strategy in the InvestingAnswers article, How to Generate Another Dividend Using Call Options.]
Covered calls are most common among investors who want to generate additional income from a particular holding. Naked options, however, are mainly used for speculating. The investor must be very confident about the direction the stock will go and have the resources available to cover any mistakes. With covered calls, the worst case is that the investor must sell the stock.