Many investors are constantly looking for ways to increase their investment returns, particulary in their IRA accounts. Those who have stock in their IRAs can use a simple option trading strategy to increase the returns they are getting from their stock holdings. This strategy, known as covered call writing, is a conservative way to generate an additional regular flow of income. It is, in fact, the only kind of option trade that is permitted inside an IRA.
Options themselves are considered to be derivatives; that is, securities that derive their inherent value from another security (namely, the underlying stock.) Options always involve two parties, a buyer and a seller. The buyer of a “call” option on a stock believes that the price of the stock will rise, and therefore purchases a call option that will allow him or her to buy the stock at a given price for a given period of time. If the stock price does rise, then the buyer can exercise the option to buy the stock at the preset price of the call, instead of the current higher market price. Then the buyer can turn around and sell the stock at the higher market price and thus make a profit. However, if the stock price does not rise, then the call will eventually expire worthless-and the buyer is out the cost of the call premium that was paid.
Conversely, those who sell covered calls do not feel that the price of the stock will rise; they believe that it will either remain steady or drop. Therefore, they are willing to be paid a premium in order to risk having to deliver the stock for less (perhaps much less) than the current market price. However, since covered call writers already own the stock that they are getting paid a premium to risk delivering, they can simply deliver that stock instead of buying it on the open market at a higher price and then delivering it to the call buyer at the lower option price. Therefore this type of option strategy is considered to be “covered”, because there is no chance that the seller will have to come up with a large sum of money in order to cover his or sale.
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