A "covered call" is a conservative stock option investment strategy. Stock options are highly volatile contracts that trade publicly in the financial markets. Most stock option strategies are considerably more risky than regular stock investments. The covered call is an exception to this. Despite its low-risk nature, you can choose from among many methods for trading covered calls. The best covered call strategies focus closely on the stock itself, rather than the option selection.
When you execute a covered call trade, you purchase 100 shares of stock for each call option you trade (unless you already own the stock), and you must maintain the stock position for at least as long as you hold the call option position. The call option you sell on top of this stock gives you the obligation to sell your shares of stock should they rise to the "strike price" noted on the contract. Because you must hold onto shares during the process, the main risk of a covered call strategy is the risk of the stock declining significantly in value. Likewise, if it rises significantly, this is also a type of risk, as it offers less profit potential than owning the stock without the option trade. Thus, the best covered call strategies involve stock that is not moving strongly in either direction.
The most important factor when executing the covered call strategies is your stock selection. You want a stock that is relatively "flat" -- not moving strongly in either direction. One way to determine this is to use moving averages overlaid on the stock price chart. Try two or three moving averages, each with a different time frame setting, such as 10-day, 20-day and 50-day. If all three are fairly flat -- not strongly sloped either up or down -- your stock's average price is not moving significantly over time. If, however, any of these are sloped in one direction, average prices are changing significantly and could impact the profit potential of the covered call strategy.
For most covered call strategies, the stock holder wants to keep her shares but sell the stock option as a source of extra revenue on the portfolio. She knows that unless the stock rises to meet the "strike price" of the option, her shares are probably safe, because the buyer of her sold option would not likely buy her shares above market price. Thus, you want to sell the call option with a strike price far enough above the current stock's price to minimize the risk of a forced sell of your shares. These are called "out of the money" options. You can choose any call option that is out of the money, but the higher the strike price, the less expensive the option, thus the less revenue you generate by selling it. Use the built-in option selection tools in your brokerage platform to make this selection.
Exiting the Position
Just because you sell a call option does not mean you are stuck in a covered call position until the option expires. If your perceptions of the stock's future change after the sale, you can simply buy the same type of call option on the open market through your broker. Buying the option closes out the "short" position created when you originally sold the call option you didn't already own. If you believe the stock is going to fall rapidly, or if it starts trending up and you want to hold onto it, this exit strategy lets you alter your exposure after the fact.
James Highland started writing professionally in 1998. He has written for the New York Institute of Finance and Chron.com. He has an extensive background in financial investing and has taught computer programming courses for two New York companies. He has a Bachelor of Arts in film production from Indiana University.