:: Profit & Loss

Profit

The maximum profit is the premium received from the short option plus the gain to be made from the long stock.

Loss

The maximum loss, should the share price fall to zero, would be the premium received minus the share price at initiation.

Break Even

The break even point is the price of the underlying minus the premium received.

Covered Calls

Covered calls are the most popular option strategy used in today's markets. They are considered low risk, and are seen as an excellent opportunity not only to gain income from the market but also to protect a long stock position from moderate price declines through the premium collected.

:: Opening Position

The position is entered by simultaneously buying shares in a particular equity and selling call options against those shares. You would do this in a neutral to moderately bullish market where you didn't expect the share price to go above the strike price of the written options.

To write one call option you need to control 100 shares of the underlying (because that option contract gives its owner the right to buy 100 of the underlying's shares). While margin is not normally required (because the short call is covered by the long stock) this will change if you choose to buy the stock itself on margin.

:: Time Decay

Usually front-month options are written or, at the very most, options with 45 days to expiry. This is because you want time decay to work as quickly as possible for you in order to render the written call worthless, and time decay is greatest in the month of expiry. Moreover, the sooner the option expires the less opportunity there is for the stock to trade higher than the strike price.

The first out-of-the-money option is usually considered the best choice for a covered call as it offers a good balance between reward (the premium to be collected) and risk. With no intrinsic value its only worth is time which, as previously mentioned, decays ever more rapidly as expiration approaches.

:: Trading Condition

Stock	General Motors
Price	$21.10
Outlook	More upside left after a lengthy rally before a correction occurs.

:: Alert Example

Action	2 Covered Calls
Buy	200 shares
Sell	2 x $22.50 Calls
Premium	$1.90/Contract
Total	$380.00

:: Profit Scenario

If GM's share price stays below $22.50, you will not be exercised and the entire premium is retained as profit. If the share price rises above $22.50, you will have two choices. You can either buy the call back and keep the stock or you can let yourself be exercised. If you choose the latter, your profit will be the premium plus the gain you made on the share price:

$380 + (($22.50 - $21.10) x 200) = $660.

:: Protection

While writing covered calls is a low risk strategy, it is also important to remember that it does not provide any protection against a collapse in the share price. If you intend to retain stock with the intention of writing covered calls each month, then consider buying a long term put (over 6 months) to protect your downside.