Covered call writing is an extension of regular call writing; if you understand the first, you’ll be able to grasp the concepts of the second one with relative ease.
To begin this introduction to covered call writing, we will first examine what call options are. Call options are one kind of option. Options are contracts that two parties enter into regarding the exchange of a particular underlying asset. The best way to understand the way options work is to observe an example.
If you were to buy a call option, you would be purchasing the legal privilege or right, without the obligation, to purchase a particular underlying asset at a pre-determined price known as a “strike price” at any time prior to the predetermined “expiration date.”
The way this works can be exemplified as follows: party A purchases a call from party B. The underlying asset in this case can be classified as 300 shares of Google with a strike price of $150/share. The expiration date is set for January 3rd. The premium is $300. So Party A would pay the $300 for the option. They would be able to buy the 300 shares of Google at any time prior to January 3rd at the $150/share strike price. This would be lucrative in the event that the market value of Google’s stock increases beyond the $150/share point. If it didn’t do so, it would not be wise to exercise and party A would either sell the option before expiration or allow the option to expire, rendering it worthless.
So how does writing a call work? If you were party B in the above scenario, you would selling (writing) a call in hopes that the price of the underlying asset either stayed the same or went down. If that was the case, you wouldn’t have to do anything. If the buying party lets the option expire, you get to keep the premium.
But say it goes up and they decide to exercise. In an uncovered call option, you would have to buy the underlying asset at the market price and then sell it to the buying party at the strike price. While you gain the premium, you lose money by selling the underlying asset a rate lower than what you paid for it. It’s quite a risk because the upside of the underlying (and your risk) is virtually unlimited, but with a covered option, it’s a lot less severe of a risk to write a call.
Covered call writing is when the theoretical party B writes a call option for an underlying asset they already own. Depending on particular scenarios, the financial risk at stake is much lower when writing a covered call because you have the stock to give them if they exercise.
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