Selling covered calls implies a prediction or belief that a particular stock price will remain the same or increase within a finite period of time. The most common length being a 3 month option. Profiting from such a prediction is the motivation why the holder of a stock will consider writing or selling a covered call option. The same, but opposing viewpoint is held by the buyer of that same option.
In a nutshell, the express purpose of selling a call option, and or buying a put option, which is the other side of the trade, is to realize a benefit, or hedge against a loss. The different ways and means to achieve such a goal is made clear once a basic understanding of how and why options work.
Fearing a lack of supply or an unanticipated rise in the cost of a needed commodity was strong motivation for the consumer of a staple to enter into an agreement with a seller to hedge or prevent such an occurrence from causing a loss or financial hardship.
Conversely, the seller of the very same commodities hoped to ensure that the fruit of his labor retained it’s value long enough to sell off his harvest and thus avoid falling prices. This simple dynamic required a buyer and seller to agree upon a contract where each hoped his best interest’s would be well served.
The modern day options market provides the same essential function. There still exists the same dynamic between producers and consumers of commodities. The benefits enjoyed by the commodity producers and consumers lent itself well to serving the same function on behalf of stock and bond holders.
It is essential to understand that what the option sellers and buyer are betting on is the perceived change in value of a stock out into the future. More often than not the contract is never actually fulfilled, meaning that the buyer does not take possession of the stock. The buyer or seller may simply trade out of a contract. Many option contracts expire without being exercised. This produces a net gain for the seller, and a loss for the buyer.
The seller or writer of a covered call option is offering to sell an obligation. This is a commitment to sell at a certain price, a specific number of shares, up to a certain date into the future at which time it expires. This obligation is expressed in amounts of 100 shares, referred to as a contract. Ten contracts equal a thousand shares, and so on.
The buyer or holder of the option is securing a right, which enables him to purchase the shares of a company, at a agreed upon price, up to a certain date into the future. The seller of a covered call option seeks to realize an additional means to profit from a stock holding, in a way that does not rely upon dividends, earnings per share, or a rise in the stocks price.
The covered call premiums can also reduce the the cost of his initial purchase if he sells contracts that equal the number shares purchased. The results however, are dependent upon the value of the under-lying equity upon expiration. In essence, covered calls are the method employed by a seller to lower his actual cost per share, or to realize an additional means of profiting from a stock holding.