Covered Call Writing -
What is it and the Reasons
for Using It in Stock Option Trading

Covered Call Writing

So, what is covered call writing? It is simply the selling of call options when one owns the underlying instruments.

There a few reasons for executing covered call, ranging from exiting position, mitigating downside risk to enhancing returns.

* Exiting position - this strategy can be useful under certain situations. To use this exit strategy, one must basically be ready to let go of the stocks, probably in the near future (i.e. within or at the end of the life-span of the option that is being written). At/close-to-the-money (and usually in-the-money since the intend is to let go of the underlying stock) call option is sold in anticipation that the underlying will remain somewhat unchanged over the life of the option. Should the stock price decline and fall below the option's strike price at expiration, the option premium that are collected and considered as gain. And one has to subsequently decide whether to sell the stock directly into the market or to write some more options into future date. Should the stock price remains the same or move up, the stock may be called away and that is fine, as it is in line with the objective.  

* To mitigate downside losses - this strategy is used when it is still desirable to own the underlying stock but the stock price remains somewhat flattish or is trending down due to overall market conditions but the fundamentals of the stock continue to be good. The intention here is to still keep the stock while at the same time use the premium collected from selling the option to buffer some losses, or even make some profit if the downtrend is very gradual .

* To improve returns - This strategy is used when the upward momentum of the underlying stocks has somewhat tanked. The view here is that the stock will still move upwards in the long run but likely to remain sideways in the short term. To enhance return, call option is then written with the view that the return will be enhance since option premiums are collected and yet the stock still remains in the portfolio and are to be kept for long term gain.

In conclusion, successful covered call writing involves knowing what you want to achieve at the end of the option expiry date, a good judgment in the movement of the underlying stock within the stipulated time and lastly, depending on your objectives, the willingness to part ways with your underlying stock when the time comes.

Covered Call Writing - Short Definition from Glossary Page.

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