In simpler terms, if for example XYZ stock is trading at $50 and you own 500 shares, you could sell 5 of the $55 March 2010 calls, which for the sake of conversation, we’ll say are trading at $1.50. So for selling five contracts, you collect ($1.50*100)*5 or $750.

The options expire on the third Friday of the month or March 19 in this case. If by March 19, XYZ is trading under $55, the stock won’t get called away and your profit is the entire $750 premium that you collected.

If by March 19, XYZ has traded above $55, say $60, then the option buyer will exercise the options, enabling her to purchase a $60 stock for $55 plus the $750 premium. Factoring the premium, her total price for the stock is $56.50. So she can purchase the stock and instantly turn around and sell the shares for a $3.50 per share profit.

Covered calls, is a low risk trade for the option writer. The worst that can happen is the stock makes a major move to the upside, and you lose out on the potential profit. For example, XYZ could run up to $95 and you lose out on all that profit because you have to give up the stock at $60 per share. However, while you’ve lost out on some potential profits, there is no actual loss to your portfolio.

Another benefit of the covered call is that it provides some downside protection to a stock holding. If XYZ drops to $45, ordinarily, you would have lost $5 * 500 shares, or $2,500. However, because you sold the calls and received the $750 premium, you limited your losses to $1,750.

Why Put On a Covered Call Trade:

You already own XYZ stock that you don’t want to sell now, but you don’t think the stock will be moving to the upside in the near-term.

You want to gain some extra profits from your stock holdings.

You want to hold on to the stock, but are worried the stock could move to the downside.

In summation, covered calls are a low risk options trade that you could use to generate regular monthly income. With 80% of all options expiring worthless, this is a trade that puts the odds in your favor.