Once you learn a little bit about writing a call and the potential risks involved, many options beginners wonder why you would ever want to write an options contract in the first place. The following is a simple example of writing a covered call and it helps explain by example why you might want to try it out

In this example, let’s assume that I’ve done some research on company ABC which is currently trading at $20 per share. My research tells me that the stock is trending a bit upward, but will probably go sideways for a while before making significant gains. So, I buy 100 shares (since one options contract represents 100 shares.) The fact that I now own the stock before I write the options contract means that this is a covered call (I own the stock and am writing against the stock I own).

Since I think the stock might hit $21.50 before expiration, I write a call contract with a strike price of $22 and set a contract price of $0.75 per share ( that’s 0.75 * 100 = $75). I’m hoping another investor will think that the price is going to go above $22 and buy my contract. Let’s say just such an investor exists and buys my contract.

Heres’ the math so far:

I bought $2000 worth of stock ($20 market price times 100 shares)
I collect $75 from the purchaser as my premium.
So I still own the 100 shares of stock, plus I now have an extra $75 in cash.

Now let’s fast forward to the the expiration date. If the stock price stayed under my strike price ($22), the contract expires and I keep the stock and $75.

However, if the stock went up to $23, the option purchaser will exercise their right to buy the stock from me at $22. In this scenario, I still win. Here’s how:
My outlays were the original $2000 I paid for the stock
I collected $75 on the option contract and was forced to sell my 100 shares for $2200.

So my profit was $2275 – $2000 = $275 (before tax and fees).

Now let’s say the stock went down to $18. I’m stuck with the stock, but I still have the $75 call contract premium which ends up offsetting my loss by $75. So if I decide to get out right now, my loss is only $125 instead of $200. So by writing the covered call, you are limiting your upside but cushioning the downside.

Some of the bigger fund managers use covered calls to free up cash. Using this technique they can lock in a purchase price for $1 a share and use their cash elsewhere. This is what is often referred to as a leveraged position.

For Further Reading:
How to Become a Pro at Trading Stock Options