Creating Higher Profits on Sale
A second strategy for the use of options involves the use of covered calls. These are calls sold by an investor who owns 100 shares of the underlying stock. The concept of selling something as a first step is alien to many investors, more accustomed to the sequence of "buy, hold, sell." With covered calls, the sequence is reversed: "sell, hold, buy."
When you sell a call, you receive the premium value. Thus, you sell the right to the buyer to purchase 100 shares of stock from you, at a specified price, on or before a specified date in the future. Previously, we stated that the risk of buying options was that time worked against the buyer. The opposite is also true. Time works for the seller.
If you were to sell a naked call (also called an uncovered call) you would expose yourself to unlimited risk. For example, if you were to sell a call with a strike price of 40 at a time that the stock was selling for $38 per share, the call will not be exercised—as long as the stock's market value remains at or below $40 per share. However, if the stock were suddenly to rise to $50 per share, the call would be exercised. You would be required to deliver 100 shares of stock for $40 per share. Without currently owning the shares, you would have to buy them at current market value ($50 per share) and immediately sell them for $40 per share.
The sale of a covered call has none of these risks, because you own 100 shares and can deliver them up if the call is exercised. This provides you with an opportunity to control a level of profits or, perhaps, to take intermediate profits without exposing yourself to risk.
Example: You bought 100 shares of stock several years ago at $22 per share. Today, the stock is worth $65. You are willing to sell at that price, but you decide to use the 100 shares for writing a covered call. You sell a call with a strike price of $65 per share, which will expire in three months. You are paid a premium of $500.
When you sell a call against shares you own, you will continue receiving dividends as long as you still own the stock. Four possible outcomes will occur:
1.     The stock rises above $65 per share and the option is exercised. In this case, you keep the premium of $500 and give up the stock at $65 per share—even though its current market value is higher. However, this is worthwhile to you because you profit in two ways: the appreciated stock as well as the option premium.
2.     The stock rises above $65 per share and you close the call by buying it. You can close out the open option position at any time by buying it. The buy cancels out the original sell position. However, you should recognize that when the stock is valued above the option strike price, the buyer can exercise it at any time. It would make sense to buy if the appreciation in the stock exceeded the appreciated value in the option. For example, let's say that as the expiration date approached, the stock was at $68—three points above strike price—but the option had only appreciated by one point, so that its current value was $600. In this situation, you might be willing to buy the option to close it, taking a $100 loss in the option in exchange for a $300 increase in the value of the stock.
Such distortions do occur because option premium includes time value, which will gradually disappear as the expiration date approaches. So it is predictable that over a period of time, some of the option's premium will fall, even if the stock is rising. By the date of expiration, only intrinsic value will remain. That means that the stock's current market value will be greater than the strike price of the covered call. If the stock is at $68 per share and the strike price is $65 per share, the call will contain three dollars of intrinsic value.
3.     The stock remains at or below the strike price of $65 per share. You close out the call by buying it for less than your original sale price. As long as the stock's market price is lower than the strike price, the option will not be exercised. However, that situation can change quickly, so as long as you have an outstanding call and you are the seller, you are at risk. It often occurs that the current value of the option is lower than the original sale price, so that it can be bought and closed out at a profit. For example, if you sell a call for $500 and it is currently valued at $200, you can purchase it and close out at a $300 profit (before trading fees).
4.     The stock remains at or below the strike price of $65 per share. You wait until it expires worthless without taking any action. The maximum profit will be realized if you simply allow the call to expire worthless. This will occur only if the current market value of the stock is at or below strike price as of the expiration date. If your call expires worthless, the entire amount you received on opening the position is yours to keep as profit. In fact, if you want, you can use the same 100 shares to cover another call as soon as the first one expires.
Fundamentalists are long-term thinkers, so option writing should not be the primary strategy for your portfolio. However, when you are willing to let go of stock because it is greatly appreciated, covered call writing is a conservative and profitable strategy. If you consider the possible outcomes, they all end up profitably. First, the call might approaches. So it is predictable that over a period of time, some of the option's premium will fall, even if the stock is rising. By the date of expiration, only intrinsic value will remain. That means that the stock's current market value will be greater than the strike price of the covered call. If the stock is at $68 per share and the strike price is $65 per share, the call will contain three dollars of intrinsic value.
rKEY POINT
Covered call writing is a conservative strategy. It eliminates the risk associated with naked call writing. Time works for the covered call writer.

Fundamentalists are long-term thinkers, so option writing should not be the primary strategy for your portfolio. However, when you are willing to let go of stock because it is greatly appreciated, covered call writing is a conservative and profitable strategy. If you consider the possible outcomes, they all end up profitably. First, the call might expire worthless, so that the premium you receive is all profit. Second, you may close out the position and make a profit on the difference in sale and buy premium levels. Third, your option might be exercised, and you keep the entire premium and earn a capital gain on your appreciated stock.
rKEY POINT
Covered call writing is a conservative strategy. It eliminates the risk associated with naked call writing. Time works for the covered call writer.

Anyone getting involved with options should first understand the risk factors involved, study the terminology carefully, and be certain that they understand strategies before making investment decisions. Options are a specialized market and not suitable for many people. However, certain option strategies can be used as one technique for portfolio management, even for the most conservative investor. As a possible starting point, contact the following organizations and request the disclosure documents listed:
Options Clearing Corporation
400 S. LaSalle Street, 24th Floor
Chicago, IL 60605
"OCC Prospectus"
Web site: optionsclearing.com
Chicago Board of Exchange
400 S. LaSalle Street
Chicago, IL 60605
"Characteristics and Risks of Standardized Options"
Web site: cboe.com (This Web site contains the full text of
both the OCC and СВОЕ disclosure documents.)
Additional Web sites worth checking include the following commercial sites, which provide many descriptions of option strategies, cross-references to other useful sites, and definitions of many different strategies:
ies-invest.com
covered-calls.com
allinthemoney.com
e-analytics.com/optdir3.htm (This site contains papers
explaining many option strategies.)