A 90-Second Primer On Covered Calls

When it comes to trading options, covered calls are one of the most popular strategies out there. Covered calls are far from perfect, but many investors find them to be very useful as a way to take a bullish position on a stock while modestly reducing both the risk and reward aspects of the trade.

By selling a call option against a long stock position, you can reduce your cost basis by agreeing to sell your stock at a fixed price. The vast majority of the time, a call option represents the right to buy 100 shares of a stock at a particular price, so typically, a covered-call trade will involve the sale one option for every 100 shares bought.

Here's a hypothetical example of a covered call trade on Apple:

• buy 100 shares of AAPL stock at $98
  

• sell 1 November $100 call option for $9

The result of this trade is a cost basis of $89 per share ($98 - $9). The buyer of the covered call position will not lose money unless the stock falls below $89, so by selling the call option against the stock position, there is a modest reduction in (not an elimination of) downside risk.

However, one should keep in mind that while downside risk is reduced, upside potential is also capped. The seller of this particular call option has agreed to sell 100 shares of AAPL at $100. So even if AAPL stock went to $150, the seller of the call option would be required to sell his/her stock at $100.

To calculate the maximum profit per share on a covered call trade, take the strike price on the option ($100) and add the premium received for ($9), and subtract from it the price of the stock when it was purchased ($98). In this case, the maximum profit is $11 per share. ($100 + $9 - $98)

And if the stock finishes below $100 at expiration, the option will expire worthless, and the call seller has earned $900 for his troubles. (total profitability at that point in time) will also depend on where the stock is) However, the owner of the call option may purchase the stock from you at $100 at an earlier time, which would only happen if it was above $100.

Please keep in mind that this post was meant to be a brief primer on covered calls, and for the purposes of simplicity, I did not include the impact of trading commissions or taxes on profitability. For more information on covered calls, I recommend reading this document from the Chicago Board Options Exchange.

Here are 5 Simple Tips for Covered call Traders!

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