*Note: This was written by a Yahoo! contributor. Sign up with the Yahoo! Contributor Network to start publishing your own finance articles.
Using covered calls is the most conservative option strategy there is. It is one that can be appropriate for someone who is holding a security, and expects little upward price movement in the stock.
Most people, even many who work in the financial services, have no idea what the term “covered call” means. There are many layers to a covered call, and that is probably why this investment strategy is so misunderstood. It involves trading options, which usually gives people who do not understand options a headache just to think about.
The strategy can help raise extra funds in your portfolio, and some use it to “decrease” the break even price for a particular security.
What is a Covered Call?
A covered call is when an investor owns a stock and sells an option (a call option) against that stock.
An option is a riskier form of investment. Using it in this way is the least risky way to take advantage of this investment product.
A call option is the ability to buy a stock at a certain price. Let us say I have 100 shares of a stock that is trading at $10. I can sell someone the ability to buy it from me for $11. Why would someone buy the right to buy something at $11? They clearly believe that the price of the stock will rise well above the $11, and that they can keep the profit.
Options also have a time frame. If you sell an option to buy that stock from you at $11, you set a time frame for the option to expire as well. Some options expire in a month, and some do not expire for over a year.
Options are always bought and sold in 100’s. When you sell a call option for $1.10, you will actually receive $110. If you sell an option to buy for $11, you are selling the right to buy 100 shares for $11 each.
In the above scenario if your stock rises above the price of $11, you could wake up one morning and notice that 100 shares of your stock are gone and you now have $1,100. If the stock is trading at $15, you will be upset. That is the risk you take with a covered call.
Covered Calls for Income Investors
The covered call investment strategy is often seen as an income generating strategy. It is common to be able to sell many options on the same stock over a period of time. If you sell an option there is a chance the option will merely expire, and you will get to keep all of the money from the sale. This chance decreases as the price of the stock increases.
More from this contributor:
Seven Ways to Reduce the Federal Budget Deficit
Using Facebook for Business
Google Tools Every Small Business Should Use