A:

A covered call is an option strategy you can use to reduce risk on your long position in an asset by writing call options on the same asset. Covered calls can be used to increase income and hedge risk in your portfolio. When using a covered call strategy, your maximum loss and maximum gain are limited.

When selling a call option, you are obligated to deliver shares to the purchaser if he decides to exercise his right to buy the option. For example, suppose you sell one XYZ call option contract with a strike price of $15, expiring next week. If the stock price closes above $15 at the expiration date, you would have to deliver 100 shares of XYZ to the buyer of the option.

The maximum amount you can lose on a covered call position is limited. The maximum amount you can lose on your long position is the price paid for the asset. If you establish a covered call position, your maximum loss would be the stock purchase price minus the premium received for selling the call option.

For example, you are long 100 shares of stock in company TUV at a price of $10. You think the stock will rise to $15 in six months and you are willing to sell the stock at $12. Assume you sell one TUV call option with a strike price of $12, expiring in six months, for $300 a contract. Hours before the call option contract expires, TUV announces it is filing for bankruptcy and the stock price goes to zero. You would lose $1,000 on your long stock position. However, since you received a premium of $300, your loss is $700 ($1,000 - $300).

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