6/18/2011 12:06:13 PM

The covered call is so often the first type of strategy an option strategist tries due basically to many investors coming from a background where they have always owned stocks. The covered call is a way to derive income from the portfolio and/or lock in some profits, to a certain degree. However, before the covered call can be employed profitably many of its nuances and certain pitfalls need to be firmly understood. Learn more about my Stock Options Trading strategies. Click here for our Trading Option Strategy.

Basically what the covered call entails is where the option strategist buys stock in increments of 100 shares and for every 100 shares sells a call option contract against it. When the option strategist actually sells the call, they are giving somebody else the right to buy the stock at a fixed price. The word covered comes from the fact the seller of the calls is not at risk if the stock climbs higher as opposed to someone who sells uncovered or naked calls and can lose an unlimited amount if the stock moves higher. With covered call writing this upside risk is eliminated because you will always be able to deliver the shares no mater how high the stock climbs.

However, there are indeed risks in the covered call strategy. The position only covers you if the stock climbs through the strike price you sold the call at but it does not protect you from the losses incurred from a large drop in the underlying stock price. The covered call lowers the cost basis of the stock just by the amount of premium received. Any drop below that new cost basis would show up as losses to the position. This risk factor needs to be clearly understood by anybody wanting to use the covered call strategy.

Covered call writers usually fall into two different camps with two distinctly different objectives. One such type is the strategist who wants to use the strategy to generate income against stock they plan to hold regardless. The other type of covered call writer employs the strategy for the sole objective of receiving high premiums. The most effective of the two covered call approaches is writing calls against stock you are willing to hold.

This income seeking approach allows the investor to receive a little downside hedge and then getting paid to sell the stock at a price they see favorable. Assuming it is fundamentally a superior stock and the investor likes it then obviously they would be more apt to assume more downside risk. In essence, they would hold the stock whether options were available or not. This approach is like getting paid by the market to place a sell order limit on the stock.

Now the approach that just seeks out high premiums has many pitfalls and can be very dangerous. Typically traders just selecting on high premiums do not appreciate the true downside risk of the covered call strategy. Many times just selecting on high premium they do no further investigation on the quality of the issue or for that matter does not even know what they do. In addition, the issues that have these high premiums attached are often times very speculative issues prone to large price declines if things do no go exactly right.

It is far better and effective if the investor concentrates on the quality of the stock first before looking at premiums. If you select fundamentally superior stocks that you would want to own for at least the intermediate term then writing covered calls can be a very profitable strategy and lower your over all cost basis of the stock. However, if you are just seeking premium and ignore the inherent strength or weakness of the stock then this type of covered call writer may have to endure some market disasters with devastating drawdowns. The bottom line is if you choose to use the covered call then by all means do so effectively.

Happy Trading!

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