Covered Call
Components
Long the underlying asset and short call options.
Risk / Reward
Maximum Loss: Unlimited on the downside.
Maximum Gain: Limited to the premium received from the sold call option.
Characteristics
When to use: When you own the underlying stock (or futures contract) and wish to lock in profits.
This strategy is used by many investors who hold stock. It is also used by many large funds as a method of generating consistent income from the sold options.
The idea behind a Covered Call (also called Covered Write) is to hold stock over a long period of time and every month or so sell out-of-the-money call options.
Even though the payoff diagram shows an unlimited loss potential, you must remember that many investors implementing this type of strategy have bought the stock long ago and hence the call option's strike price may be a long way from the purchase price of the stock.
For example, say you bought IBM last year at $25 and today it is trading at $40. You might decide write a $45 call option. Even if the market sells off temporarily it will have a long way to go before you start seeing losses on the underlying. Meanwhile, the call option expires worthless and you pocket the premium received from the spread.
Protected Covered Call
A "protected" covered call involves buying a downside (out-of-the-money) put together with the covered call i.e:
Buy Stock, Sell Call Option and Buy Put Option.
The profile of a protected covered call looks like call spread and has the benefit of limiting your downside risk in the event of a large sell off in the underlying stock/future.
Call Writer promotes this strategy as a Super Put.
Monthly Income
Covered and protected covered calls are usually the strategies used by advisory services that promote option strategies for "generating monthly income" while "protecting capital". Services like Call Writerwill provide you with real time lists and a trade management calculator where you will learn how to select, plan and manage covered call trades for consistent monthly cash flow.
Their method shows you how to limit your risk to a small percentage of your total account.
Covered Call Video Explanation
In the video below, Suze Orman explains the covered call strategy in very slow, easy to understand options market segment.
"Start seeing losses on the underlying" - you are long the stock at $25. You sell a $45 call option. The stock has to sell off by 44% before you start losing on the underlying. But you still keep the option premium.
What exactly are the risks if the stock soared? You've sold a call option and have locked in the profit of strike - underlying (plus premium).
How come you didn't mention the risks if the stock price soared instead of dropped?