Covered Call

Components

Long the underlying asset and short call options.

Risk / Reward

Maximum Loss: Unlimited on the downside.

Maximum Gain: Limited to the premium received from the sold call option.

Characteristics

When to use: When you own the underlying stock (or futures contract) and wish to lock in profits.

This strategy is used by many investors who hold stock. It is also used by many large funds as a method of generating consistent income from the sold options.

The idea behind a Covered Call (also called Covered Write) is to hold stock over a long period of time and every month or so sell out-of-the-money call options.

Even though the payoff diagram shows an unlimited loss potential, you must remember that many investors implementing this type of strategy have bought the stock long ago and hence the call option's strike price may be a long way from the purchase price of the stock.

For example, say you bought IBM last year at $25 and today it is trading at $40. You might decide write a $45 call option. Even if the market sells off temporarily it will have a long way to go before you start seeing losses on the underlying. Meanwhile, the call option expires worthless and you pocket the premium received from the spread.