Writing covered calls is considered to be one of the more conservative option trading strategies. Many people hear the term so often but many still don’t really understand what exactly a covered call is.
It involves buying shares of stock and selling a call option.
Options are seen by some as a risky investment vehicle. However, when used in conjunction with owning stock it becomes an easy way to generate extra cash flow.
So Why Covered Calls?
You may be asking what makes the call ‘covered’. There are option trading strategies where you can sell covered calls or sell ‘naked’ calls. A covered call is merely when you sell an option contract while also owning the underlying stock.
On the other hand, if you sell a call option contract and you do not own the stock, you would be selling a naked call.
When selling a call you are basically giving someone else the right to buy shares of stock at a predetermined price. If you already own these shares of stock you would be writing a covered call. If you sell the call options and you do not own the stock you would be writing naked calls.
Selling naked calls or selling call options while not owning the stock can be more risky than if you did currently own the stock. If someone were to be called out or have to sell the stock that they didn’t own, they would first have to buy the stock at the current price and then sell them to the owner of the options for the agreed price.
This can still prove to be a profitable strategy although most brokerage firms require you to have more money on reserve in the event you are called out and have to purchase the stock.
It is for this reason that selling calls on stock that you currently own tends to be the preferred strategy.
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