Chapter 9. Covered Calls

Investors Are Always interested in increasing returns without having to accept more risk. Therefore, they are attracted to covered calls by marketers' assurances that this elusive combination is within reach. The real question is whether writing covered calls represents an efficient investment strategy, or if there are better ways to achieve the same objective. To answer these questions, we'll compare covered calls to a similar passive strategy. However, let's begin with some helpful definitions.

A call is an option contract that gives the holder the right, but not the obligation, to buy a security at a predetermined price on a specific date (known as a European call) or during a specific period (known as an American call). A covered-call strategy involves the investor's writing (selling) a call option on stocks that are already in his or her portfolio. In doing so, the seller of the option gives up all of the potential for appreciation above the option strike price, but, in exchange, receives an up-front premium. If the call expires without being exercised, the portfolio return is based on the call premium and the value of the stock that the call writer still owns. Alternatively, if the call is exercised, the call writer receives the call premium and surrenders the stock at the strike price.

It is important to note that one of the "costs," besides transactions fees and taxes, of a covered-call strategy is the lost upside opportunity. Essentially, the covered-call ...

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