Understanding a Covered Call

One of the huge advantages to trading options is the ability to trade in any type of market environment. Whether the market is moving higher, lower or sideways, there are option strategies that can make profits.

However, sometimes the sheer number of strategy choices can be a detriment. Nonetheless, it doesn't mean we should just stick to one strategy, as this will take us out of the market during some of the best times to be in. One strategy that tends to get more attention than any other -- though it is often used incorrectly, adding to the risk of the trade -- is a covered call.

Before we talk about the pros and cons of a covered call, let's first define what it is. A covered call is the selling of a call against an underlying security. For example, we might buy Microsoft (MSFT Quote) stock at $20, and then sell a 20 call against the stock. This strategy has been popular among so-called options gurus because of its simplicity. It's also considered to be safe, making it a strategy of choice for IRAs.

But there are better strategies to use than a covered call. Nonetheless, there's a place for this strategy, which we'll also discuss.

An options contract gives us control of 100 shares of the underlying security. Thus, if we want to stay covered and not add to our risk, we would need to sell one call for every 100 shares owned.

If we sell a contract without owning the underlying security, then we're considered naked and have unlimited risk. For example, if we buy 1,000 shares of Microsoft stock, we could sell up to 10 calls and still be covered. The idea behind a covered call is that we can pay down the cost of the long purchase by selling calls and bringing in the premium.

Covered Call Strategies

Thus, there are two ways to enter a covered call strategy. One is to buy the shares and sell the calls simultaneously. The other is to sell calls against a long-term holding you already have. The latter is the one time that entering covered calls might be appropriate. To understand why a covered call can be riskier than often discussed, we need to take a look at a risk graph.