A covered call is a popular strategy for investors who already own a stock. It involves selling a call option for a stock you hold. Since one options contract typically represents 100 shares, you would sell one call option for every 100 shares you own.

The word "covered" is key. It means your obligation to sell the stock (if the option buyer chooses to exercise it) is covered by the shares you already possess. This makes it a much more conservative strategy than selling an option without owning the underlying stock, which is known as a "naked call."

Let's walk through how it works. Imagine you own 100 shares of a company, let's call it XYZ Corp, which is currently trading at $48 per share. You believe the stock might not move much in the short term, so you decide to sell a covered call.

You sell one call option with a strike price of $50 that expires in one month. For selling this option, you immediately receive a payment, known as a premium. Let's say the premium is $2 per share, so you collect $200 ($2 x 100 shares).

When the option's expiration date arrives, one of two things will happen.

Scenario 1: The stock price stays below $50. If XYZ Corp's price is at or below the $50 strike price at expiration, the option expires worthless. The buyer won't exercise their right to buy the stock from you for $50 when they could get it cheaper on the open market. You keep the $200 premium and your 100 shares of XYZ. You can then choose to sell another covered call for the next month.

Scenario 2: The stock price goes above $50. If XYZ's price is above $50 at expiration, say $53, the buyer will exercise the option. You are obligated to sell your 100 shares to them for the strike price of $50 per share. You receive $5,000 for your shares (100 x $50), and you also keep the $200 premium you collected upfront. Your total proceeds are $5,200.

The main benefit of a covered call is income generation. You get paid for selling the option, which provides an extra return on a stock you already own. This premium also provides a small buffer if the stock price declines. In our example, the stock could fall to $46 before you start to lose money on your original investment ($48 purchase price - $2 premium).

However, there are risks. The biggest trade-off is that you cap your potential upside. If XYZ Corp's stock had shot up to $60, you would still have to sell your shares for $50. You would miss out on that extra $10 per share of profit. You're trading potential for big gains for the certainty of a smaller, immediate income.

Additionally, you still face downside risk. If the stock price plummets, the premium you received will only offset a small portion of your losses. You are still, first and foremost, a shareholder exposed to the stock's performance.

Now that you understand the mechanics of a covered call, you can start to see how it might fit into an investment strategy. It’s often used by investors who are neutral to slightly bullish on a stock and want to generate income from their holdings.