The use of "covered call" writing is an investment strategy that offers the INVESTOR (as opposed to the speculator) several advantages of stock ownership. First, the use of a covered call strategy offers downside protection and secondly the call option generates cash flow. Here's how it works:
Lets assume you buy 500 shares of a stock in April at $50 a share. At the same time you sell the July 55 call option with a price of $2.5. Because you have sold covered call options, the stock can drop by $2.5 per share and you will have protection (or no loss) up to that point. The $2.5 represents 5% downside protection. It also represents $1,250 in cash flow since that's the amount you receive when you sell the option. Conversely, should the stock rise above $55 per share and stay there through the 3rd Friday in September (all equity option contracts expire the 3rd Friday of the respective month) you would be forced to sell the stock at $55 per share for a total return of 15%. 55+2.5 = 57.50 $50= 7.50 per share or 15%. Not bad for three months work. If the stock trades to say 53 per share through the 3rd Friday in September, the option would expire worthless and the $2.5 you originally collected would be booked as profit and you would still own the stock. You could then sell the stock, or hold it and repeat the process.
While this strategy can offer limited protection from a decline in price of the underlying stock and limited profit participation with an increase in stock price, it generates income because the investor keeps the premium received from writing (or selling) the call. At the same time, the investor can appreciate all benefits of underlying stock ownership, such as dividends and voting rights. . The covered call is widely regarded as a conservative strategy because it decreases the risk of stock ownership.
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