When we think of stock investing, it’s usually the buy-and-hold variety—pick a stock or (ETF), watch it (hopefully) grow over time, and along the way. And there’s nothing wrong with that—it’s the traditional path to .

　　But if you like the idea of enhancing that stock ownership with a little extra income, and you’re comfortable taking the risk of selling your shares on a sudden, unexpected rally, the might be for you. 

　　A covered call involves taking a short position in a call option on a stock you own, typically at a strike price that’s out of the money (i.e., higher than where the stock is currently trading). The strategy is also called a buy-write strategy, because in options lingo, to “write” an option contract means to sell it.

　　As with all options strategies, a covered call requires you to and decide whether the terms are in line with your objectives and risk tolerance.

　　Call options: A quick recapIf you’re familiar with, you know that a call option contract gives the owner (i.e., the buyer) the, but not the, to buy 100 shares of the underlying stock or ETF at a specific price (the “strike” or “exercise” price) by a certain date (the option’s “expiration date”). The premium is what you pay for that right.

　　For example, if stock XYZ is trading at $100 a share, and you paid $2 for a March 105 call, you could, at your discretion, buy the stock for $105 on or before the third Friday in March. If XYZ rises to $110, you would exercise your option, buy 100 shares of XYZ for $5 less than it’s currently trading, and either hang onto it or sell it at a profit (minus the $2 you paid for the option). Or you could save yourself a step and simply sell the call option in the open market, because its with the stock price.

　　When you sell a call option, it’s the opposite: You cede the to make an exercise decision, and you accept the to deliver 100 shares of XYZ at the option owner’s discretion. But to compensate you for accepting the obligation, you are paid a premium. It’s much like how an company charges a premium in exchange for its promise to pay for property damages.

　　Short call vs. covered callWhen you sell a call option contract, you’re making a promise to deliver 100 shares of XYZ at the call owner’s discretion. And if you don’t already own those shares? That’s called an or . But it’s a very risky strategy—after all, a stock can only fall to zero, but it can theoretically rise to infinity. Many brokers won’t allow you to sell a naked call option unless you have a lot of capital in a and are permitted to .  

　　But if you do own at least 100 shares of XYZ, that short option is a . That’s because if XYZ rallies above the strike price, and the option’s owner decides to exercise the option, you’ve got the shares to cover it. See figure 1.

　　Covered call exampleSuppose you bought 100 shares of XYZ for $100 a share (your initial cost basis), and the stock is currently trading for $110.

　　Once you sell a call option for $4.50, regardless of what happens between now and expiration, your cost basis (i.e., your breakeven price for buying the stock) is now $95.50. You paid $100 for the stock, but you’ve already earned $4.50 for every share. If XYZ were to drop back down to $100 (your initial purchase price), you’d still be up $4.50 on the deal because of the short call premium.

　　If so, your shares will be called away. With any share price over $115, your short call option position will be assigned, and you’ll be required to deliver 100 shares of XYZ. (But that’s OK, because you already own 100 shares of XYZ to cover your short call.) So although you get that $4.50 head start, you lose your stock, plus any additional upside potential over and above the $115 strike price.

　　On the other hand, if you had targeted $115 as an exit point anyway, the covered call provided a way to hit your target of a $15 winner (from your original purchase price of $100), plus the $4.50 premium, for a net of $19.50 (or $1,950 for 100 shares).

　　And if XYZ stays below $115 from now until expiration? The call option expires worthless, you keep the entire $4.50 and your shares, and decide whether to do it again.

　　Setting a covered call strategyAs with any, before you place a covered call trade, it’s important to understand the risk parameters and set your expectations accordingly. A veteran trader will, at minimum, go through the following decision algorithm:

　　The bottom lineIf you’re ready to try a covered call, start small. If you own several hundred shares of a stock, start by selling just one 100-share option contract. Don’t sell an option that’s too close to the current share price (“at-the-money,” in options lingo) because, even though you’ll collect a higher premium, there’s a greater likelihood that your shares will be called away.

　　Selecting a strike and expiration date is a blend of art and science, punctuated by a deep understanding of option risk metrics such as (what traders call “option greeks”). For example, some option pros look for strikes within a certain band, say a 0.30 (i.e., a 30% chance of being exercised), in an option with 30 and 40 days until expiration, to collect a decent premium and catch a certain .

　　And remember: You don’t have to hold an option until expiration. In fact, most options are closed out (or ) before expiration. Once an option—or any asset you hold—is no longer serving your objectives, it’s a good idea to close it out and move on.