Other than earning and hedging in buying calls and puts, investors can also earn profits by selling covered calls. If you sell a call option this means that at the price of the premium you will create an option contract where you are obligated to sell 100 shares of stock if the buyer of the option chooses to exercise that option. If you sell a covered call this means that when you sell the call option you actually own the underlying stock of that call option. This is in contrast with an uncovered or naked call option where the writer does not own the underlying stock of the call option. The primary reasons why investors write covered calls are: to earn more profit from the underlying stock through the premium paid by the holder; and to protect himself from a decrease in the stock prices but only up to the amount of the premium. To explain these benefits I will use illustrations. Note, however, that for purposes of simplicity, tax considerations, commissions as well as transaction costs have been omitted in my illustrations. Also, the call options here are assumed to be American style, which means that the call option can be exercised any time before the expiration period.
Let us assume that you buy 100 shares of Stock C for $50 per share. In order to earn more profit from Stock C you decide to sell a Stock C July 50 call option at the premium of $4. This means that for the premium of $400 (for all 100 shares) you are prepared to sell your 100 shares of Stock C at $5,000. The $4 premium per share constitutes added income for you which represent an 8% turnout from each of your $50 per share of Stock C. This also means that you are protected from a decrease in the prices of Stock C but only up to the extent of $4 per share. Assuming that the stock price of Stock C declines to $40 per share, you would have lost a $1,000 value on your stocks ($5,000 – $4,000) but since you sold a call option for $400 you would have reduced your losses to only $600 instead of $1,000. This will be the scenario if the holder exercises the call option. If he does not exercise the call option you would have gained the $400 and still have the 100 shares of stock that you could keep in hopes that it will appreciate or you could sell at $40 per share. If the stock prices of Stock C increases to $60 per share and the holder exercises the call option, you would be forced to sell him the 100 shares of Stock C at $5,000. Your total selling price would be $5,400 ($5,000 + $400 premium). The $6 per share lost would constitute your opportunity cost in writing a covered call. It is thus clear that in selling a covered call a writer passes up the chance to benefit in an increase in stock prices that are beyond the strike price and also bears the risk of a decrease in stock prices that can be reduced by the premium paid.
However, as a call writer you could write an in-the-money call option and ask for a bigger premium. This would yield you higher profits and greater protection from stock price decrease but you run the risk of the holder exercising the option. If you write an out-of-the-money call option you would have a lesser premium but also have a lesser chance that the holder will exercise the call option.