Option strategies that limit your risk: Sell a Covered Call

The Write a Covered Call strategy is probably the most frequently misused option trading strategy. Proponents of covered call writing imply that writing a covered call is tantamount to picking up "free money", since it allows you to generate additional income by simply selling an out-of-the-money call option against a stock or futures contract that you already hold. They also trumpet the idea that this strategy provides downside protection. And to some extent, both of these assertions are true. However, most traders who employ this strategy have no idea that writing a covered call actually limits their upside profit potential and provides only a limited amount of downside protection.

For example, if you own 100 shares of IBM and the stock is trading at 126, you might be able to sell a 130 call option with 21 days until expiration for 2 points, which means you will receive $200 from the option buyer. This $200 is yours to keep. Over the next 21 days one of several things will happen:

1. For each point IBM rises above 130, you will make $100 per point on the stock and lose $100 per point on the option you sold. In other words, your maximum profit potential is capped if the stock rises above $130.
   
2. Selling the call at a price of 2, gives you 2 points of downside protection. Thus, if IBM falls to 122 at option expiration, the two points you made by selling the option will offset the two points you lose on the stock. If IBM falls below 122, the covered call offers no additional downside protection.
   

Because covered call writing limits your upside potential and offers only limited downside protection, it is important that the Write A Covered Call strategy be employed only at the most advantageous times. Covered calls should only be written under the following circumstances:

1. The volatility for the options is very high (to maximize the amount of premium received).
   
2. Write only out-of the-money options (this strategy is not a market timing strategy. It is simply an attempt to generate additional income by selling out- of-the-money options and letting time decay work in your favor).
   
3. The best time to write a covered call is after the stock or futures contract you are holding has already experienced an advance in price. If the stock then enters a consolidation period, you can generate income by writing a covered call and watching it expire worthless.
   

When To Exit Covered Calls

Before entering trade, decide what you will do if underlying security rises sharply while you are short a covered call. Your choices are:

1. Buy back call option (probably at a loss) only.
   
2. Buy back call option (probably at a loss) and sell another further out-of-the- money-call.
   
3. Let stock be called away.
   

Exiting at a Loss

1. If the stock price falls:
   
2. If you have a stop-loss price for the underlying security and that price is hit (thus prompting you to sell your stock), buy back the call option at that time.
   
3. If you are simply holding a stock for the long-term, then let call option expire worthless.
   

Exiting at a Profit
Maximum Profit (MP):
MP = (Strike Price of option sold + premium received) - Stock Price
If 80% of MP is achieved, you may consider buying back the covered call and selling a further-out-of-the-money call.

Remember that using the Sell A Covered Call using a stock on which you have a large unrealized profit can cause you to realize the profit for tax purposes if the stock is called away.