How to Trade Covered Calls

by Mike Parker

There are two primary ways to make money from your stock investment. Your stock may pay a regular quarterly dividend, or your stock may increase in value and you can realize that gain by selling your stock. You may also be able to increase your return on your stock investment by trading covered call options.

Open an account with an investment brokerage firm that offers options trading. You will need to provide your broker with certain required information, which typically includes your Social Security number, your driver's license number, and information regarding your finances and investment experience. Although trading covered call options is considered to be a conservative investment strategy, it can still be a complex transaction, and your broker will want to know that this strategy is appropriate for your investment objectives.

Deposit a sufficient number of shares of the underlying stock with your brokerage firm to meet your obligation in the event your covered call option is exercised. Trading covered calls requires you to actually own a sufficient number of shares of the underlying stock. Your broker will probably want to hold those shares in street name for delivery purposes.

Observe the market to determine current price of the underlying stock as well as the the expiration date, strike price and market price of the call option you wish to trade. Place a sell order with your broker for the number of covered call options you wish to sell. You have the option of placing the order at the market, which will execute at whatever price the market offers, or you may place a limit order, which specifies the lowest price you are willing to take for your option. Once the trade is made, the funds for the trade will be placed in your brokerage account upon settlement.

Follow the market price of the underlying stock. If the price of the stock drops, the value of the covered call will likely drop as well and you may be able to buy back the call options for a lower price than you sold them for, resulting in a net gain on the transaction. You also have the option of doing nothing. If the expiration date passes while the price of the stock is below the strike price, the option will expire and become worthless to the buyer, in which case you will still own your stock and you will have earned the premium for selling the covered call. If the market price of the stock rises above the option's strike price, the buyer may exercise his right to purchase your stock. Your brokerage firm will deliver the stock and you will receive the strike price in addition to the premium you received for selling the covered call option.

Tip

  • Trading covered call options limits your profit potential on your stock, but it also offsets some of the downside risk. Consider trading covered calls when you feel like your stock has positive long-term growth potential, but you don't feel like the stock price will make a significant short-term move.

Warning

  • Stock options are not insured by the Federal Deposit Insurance Corporation or any other entity of the federal government. You may lose some or all of your investment. A stock option's past performance is never a guarantee of future results.

About the Author

Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.

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