I'll assume in this article that you already have the basic understanding of stocks and options.  If not then it would be worthwhile to read about these investments first.  The covered call strategy brings together stocks and options to form a third strategy…a cash flow strategy.  The covered call strategy has a number of benefits that makes it an essential element of your wealth creation arsenal, namely it's:

  • Simple and quick to implement
  • Easy to understand and track
  • Produces fantastic cash returns on your capital
  • Helps protect your portfolio from market fluctuations
  • Fairly conservative…i.e. it's not a high risk strategy
  • A fairly hands-off investment once made which frees your time to concentrate on other things

So what type of returns should you expect from the covered call strategy?  Well let's examine the strategy and example first because this strategy has a range of possible returns.  But before we rush out and implement this strategy I would like to highlight to you that the covered call strategy should only be used by those that already invest or intend to invest in stocks.  Investors should not buy stocks simply to implement this strategy for one simple reason...there are better strategies available to you.  That is not to say that the covered call strategy does not work for in this context...it does...it is just to say there are better strategies available.  However, if you have a stock portfolio or intend to then the covered call strategy is a fantastic way of generating excellent extra income and at the same time lowering your investment risk.

Most investors simply purchase funds (whether actively managed or passive index trackers) and take a totally hands-off approach.  Some more adventurous ones invest directly in stocks also in the hope that over time they'll be able to enjoy watching their stocks rise in value.  Their returns, also referred to as their payoff, is shown by a 45% line on a payoff diagram as shown below. 



Informed investors…wealth creators…apply a different strategy.

The covered call strategy generates extra income by selling call options on stocks you own. You can think of it like renting your shares, much like you would rent out an investment property.  Unsophisticated "investors" buy stocks and don't rent them out.  Would you buy and investment property just for it's capital return and not rent it to someone to generate an income for you?  Of course not...well the same applies to stocks.

When I say the word "options", which are derivatives, many people instantly think risk.  If you find yourself thinking these types of thoughts you don't know options, and derivatives in general, well enough and you need to.  Any investment is risky if you don't know what you're doing.  As a former professional derivatives trader I know that derivatives need not be feared, but they must be respected.  You need to thoroughly understand what you're investing in if you ever hope to be wealthy.  Ignorance is not bliss!

Selling, also known as writing, calls on stocks is not risky.  It's a conservative investment strategy.  In fact, it is much less risky than just investing in stocks by themselves.

The mechanics of the covered call
The covered call trade is a combination trade whereby you own a certain amount of stock and you sell call options of the same value.  As the seller of the call options you receive a cashflow (the premium) from the buyer.  You are effectively selling to the call option buyer the upside benefit of the stocks above the option strike price.  You've agreed to sell your stock for a specific price by the option's expiration date.  They in turn pay you the premium for that benefit.