When it comes to trading options, you can trade a call or a put, and you can either buy or sell. But in practice, you can use combinations of various option contracts to tailor your overall market exposure to your liking.

You can use options to swing for the fences or to hedge against your existing stock positions. No matter how you want to balance your potential risk and reward, you can probably find a way to do it via options.

One simple and basic trade strategy that beginner options traders like to use is the covered call. This strategy provides income while limiting your risks from the trade. Here’s how it works.

Covered calls are one of the most popular strategies among investors seeking to generate additional income from their stock portfolios. This conservative approach allows investors to capitalize on the stocks they already own, offering a way to enhance returns while maintaining some level of downside protection.

A covered call is an options strategy where an investor sells call options against shares of a stock they own. The term “covered” refers to the fact that the investor owns the underlying shares, which “cover” the obligation to deliver the stock if the option is exercised.

When you sell a call option, you give the buyer the right (but not the obligation) to purchase 100 shares of the underlying stock at a specified price (the strike price) before a certain date (the expiration date). In exchange for this right, the buyer pays you a premium upfront.

Let’s break down the covered call strategy with an example:

Stock Ownership. Suppose you own 100 shares of XYZ Corporation, currently trading at $50 per share. You believe the stock will trade sideways or experience modest gains in the short term.

Selling a Call Option. You sell a call option with a strike price of $55 and an expiration date one month away. For selling this option, you receive a premium of $2 per share, or $200 in total.

Possible Outcomes

Stock Remains Below $55. If XYZ’s stock price stays below $55 by the expiration date, the call option expires worthless. You keep the $200 premium as income, and you still own your 100 shares.

Stock Rises Above $55. If XYZ’s stock price rises above $55, the call option is likely to be exercised. You must sell your 100 shares at the $55 strike price, regardless of how high the stock has risen. You still keep the $200 premium, but you miss out on any gains above $55.

Stock Declines. If the stock price falls, you still keep the premium, which can help offset some of the paper losses on the stock. However, you will still hold the underlying shares and be subject to any further declines in value.

The primary benefit of a covered call strategy is the premium income received from selling the call option. This income can enhance overall returns, especially in a flat or mildly bullish market.

While covered calls don’t protect against all losses, the premium income provides a buffer that can help offset minor declines in the stock’s price.

Investors can tailor covered calls to their market outlook by choosing strike prices and expiration dates that match their expectations. A higher strike price will generate less premium but allows for more upside potential, while a lower strike price offers more premium but caps potential gains sooner.

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