When you buy a stock, you are looking to make money two main ways, via price appreciation and dividends. However, there is another way to squeeze out more income out of stocks you already own, which is by writing, or selling, covered calls.

A call option gives the buyer of the option the right (but not obligation) to purchase 100 shares of the underlying stock, per contract, at the option strike price on or before expiration (for American options). Note that generally, call option holders do not exercise the option before expiration even if the contract is in the money.

The reason is that they would need cash to exercise the call to buy the stock. In general, cash is considered more valuable because of the flexibility it offers. If they have shares of the stock, they would have to sell to convert to cash. Whenever they hold the stock, they also take the risk that the stock may go down before they can sell. If they don’t want to hold the option anymore, they could just sell it before expiration rather than go through the extra step of option exercise.

Taking the Short Side

When you write a call, you are taking the opposite position to the option buyer. If the option holder exercises the call option, you have the obligation to sell 100 shares of the underlying stock per contract to the option holder at the strike price.

If you write a call without owning the underlying stock, it’s called a naked call. Such a strategy is considered high risk. This is because there is theoretically no upper limit to how high a stock could go. If the stock moves suddenly against you, you may need a lot of cash to buy the stock to deliver to the counter party.

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For example, let’s say you sell three calls with a strike price of $55 against stock XYZ, which trades at $50 now. Suddenly, there’s news that the company is being acquired by another larger company, and the stock jumps to $80. Your option is going to be deep underwater and if you don’t have enough equity in your account, you will face a margin call from the broker. That will force you to liquidate some positions or put in more cash.

On the other hand, if you already have 300 shares of XYZ in your account, in the event the call is exercised against you, you simply sell what you already have. There is no need to buy the stock on the market and no risk of margin call.

Like Extra Dividends

So far, I’ve only talked about the bad parts of writing a call because I want you to be aware of what could go wrong. However, when things go right, you could be generating quite a bit of extra income.

Recall that I mentioned that calls tend not to be exercised early? This means that even if XYZ moves over $55 during the life of the call option, as long as the stock ends up at $55 or lower at expiration, the call very likely won’t be exercised. You can then sell another call against your XYZ shares and collect another premium. In fact, you can keep selling calls until it is eventually called away.

If XYZ pays $1 in dividend a year, and you sell two calls during a 12-month period for $1 each, you would have generated an extra $2 per share out of your holding. In practice, you could sell more than just two calls per year if you work with shorter-dated call options, so realistically you could squeeze out even more cash out of what you own.

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