| A covered call option strategy is considered a conservative relatively safe option strategy, which can be used to generate rent from your investments in neutral to slightly bullish markets. To implement a Covered Call option strategy you firstly have to take a long position in a stock and then write (sell) a call option against that stock.
For example let us assume you buy 1,000 shares in Company ABC, which cost $10 each. You then sell 10 American style call option contracs (with American options 100 shares = 1 option contract) that expires in 3 weeks, at an $11 dollar strike price, for 25 cents per share i.e. $250. One of three things can now happen:
1. Company ABC trades sideways, therefore in 3 weeks the price is still at $10. As a result the $11 call option expires worthless therefore you still own 1,000 shares of Company ABC and have made a gross return of 2.5%
2. Over the 3 weeks, company ABC rallies 15% to $11.50, which results in the option is then exercised. You then sell your 1,000 shares at $11 making $1 profit, plus the $250 from writing the covered call. You total gross return for the 3 week period is 12.5%
3. The share price of Company ABC falls 10% to $9 over the 3 week period. The option expires worthless however as you sold the call option you have lowered your cost of purchase by 2.5% therefore your actual loss is approximately 7.5%. During the 3 week period if you had sold an America style covered call option, you could have bought it back and then sold the stock if the price of ABC traded below a stop loss value, or alternatively sell the stock and have a naked exposure to the covered call.
It should be noted that rather than selling Out of The Money (OTM) covered calls, if the market turns bearish investors can sell In The Money (ITM) covered call. In the previous example an investor could have sold the $9 ITM call option rather than the $11 OTM call option. For example, if an investor sold the $9 call option for $1.25 and three weeks later the market pulled back and Company ABC fell to $9.50, the option would be exercised. The investor would have to sell their shares in Company ABC for $9, however as they collected $1.25, the gross profit would be 25 cents per share.
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