4.1.2.2.2. Hedging with Covered Calls and Puts to Increase Income
You may also hedge a position by shorting a call or put and using the income gained to lessen possible losses. This is not the best protection, however. The best protection always comes from buying an option, just as you have to buy insurance.
When an investor is long a security, it means that the investor owns the security. When an investor owns the underlying security and decides to sell a call option on it, the option is called a covered call. If the option buyer exercises the option and asks for delivery, the call writer already owns the security and does not have to cough up additional money to buy it in the market.
Writing covered calls can increase income in a portfolio. Remember, however, that the investor will not be able to participate in the upside gains in the stock because when the stock price exceeds the strike price, the holder of the call will exercise the call, and the investor will be forced to sell the stock at the strike price. Thus, writers of covered calls limit their losses and their possible gains.
Example: John owns 100 shares of WXYZ but wants to earn some extra income. John writes a call option on WXYZ with a strike price of $40 and pockets a $2-per-share premium. The holder of the call decides to exercise the call when the stock price hits $45. John delivers his 100