Covered calls are one of the easiest ways you can boost your income without taking on too much risk.

Unfortunately, most investors won’t even consider doing it. That’s usually due to a misconception about options — or the risk involved.

But our job is to demystify trading strategies like covered calls for regular investors, so that you can use them effectively.

Let’s dive in…

What Are Covered Calls?

Option trades, like any other market trade, involve both a buyer and seller.

The buyer of a call option has the right to buy the underlying security at the strike price before the expiration date. The option seller, or writer, is granting the call buyer that right. And they must deliver the underlying security if the call option is exercised by the buyer.

If the option writer already owns the underlying security when the trade is opened, it is said to be covered.

So if a trader owns 100 shares of Apple (Nasdaq: AAPL), they could write one covered call against those shares. If AAPL rises above the strike price before the exercise date, the buyer could exercise the option. The shares are sold from the option writer’s account at the strike price. The covered call position would lead to a small premium collected and a sale of AAPL at a price the writer agreed to accept.

How Traders Use Covered Calls

Covered call writing is usually considered to be a low-risk, income generating strategy. One way traders mitigate the risk of having to sell their underlying position is to sell deep out-of-the-money calls. This allows the trader to receive small premiums while continuing to benefit from appreciation in the stock.

Let’s look at a hypothetical example. A trader owning 100 shares of AAPL could sell a call with a strike price that is $10 above the current market price and expires in 30 days. They would immediately receive a small premium of maybe $1 a share.

If AAPL goes up by less than $10 or falls over the next 30 days, then nothing is required. Then a covered call increases the trader’s profits by an additional $1 per share. If this strategy is repeated over time, it can deliver a significant amount of income to the trader. If AAPL rises, then the trader will be able to sell at a profit.

In another scenario, some traders may sell a security by using a covered call. The goal is to get a slightly higher price on the transaction if the call is overvalued relative to the underlying security. If the trader with 100 shares of AAPL wanted to sell at the market and an at-the-money call was selling for $1 on the expiration date, they could sell the call. This would allow them to make an additional small profit on the trade when the call is exercised.

These opportunities are rare, but they are possible in fast-moving markets where volatility is relatively overpriced. Volatility is a critical factor in determining the options price, as we’ve mentioned before. And if the level of volatility changes abruptly, market opportunities like this can exist for brief periods.

Why This Matters To Traders

Covered call writing can allow a trader to increase their income and limit the risk in some trades. This strategy is often used with stocks that pay a dividend to generate additional income.

In addition to the dividend, the trader could generate returns of several percentage points on the covered calls. Another way of looking at it is that the premiums earned effectively reduce the cost basis in the underlying stock.

And if the stock appreciates, then the trader gains from that as well. If the strike price is greater than their initial purchase price, the trader will be able to sell their position with a gain. They could even reinvest the profits into another covered call position. By repeating this process over time, large profits are possible.

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