Covered Calls

Selling a covered call is often the first trade a new option trader executes, and with good reason. Covered calls, sometimes called overwrites, take advantage of several of the phenomena we discussed in Part Two, the volatility risk premium being the most important of the phenomena.

A covered call is executed when you sell a call option against stock that you own. The risk from the short calls is “covered” by ownership of the underlying stock. Importantly, you sell calls representing a number of shares that is equal to or less than the number of shares you own.

It’s important to stress that we’d never sell uncovered or “naked” call options. The risk is just too great, but owning the underlying stock in an amount at least equal to the shares represented by the calls we sell means we’ve defined our risk if the stock rallies, even if the stock rallies tremendously. If the underlying stock rallies then ultimately the price of the call option our trader is short will rally $1 for each $1 in the price of the underlying stock. Each $1 increase in the price of the call option will cost our trader $100 per option shorted. However, each $1 increase in the price of the underlying will earn our trader $100 per round lot of 100 shares even if the stock rallies hugely. As long as our trader has sold calls representing the number of shares of stock owned, the stock will cover the short calls. Table 10.1 shows the relationship between covered and naked calls for a trader ...

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