Covered call writing is a strategy whereby an owner of a stock sells options on the stock in an effort to generate income from a potentially underperforming or flat trading stock. The position the owner of the stock takes is that the stock will not trade well in the near term but may in the long term perform well. In selling an option the owner of the stock sells an option to buy the stock in the future at a set price today. This is a contract between the owner of the stock and the buyer who has payed a premium for the option to buy at a specified date contained in the contract. If the stock trades flat at the future date, the option expires worthless. The owner of the stock outperforms the stock and pockets the premium and the buyer is out. If the stock price declines by the expiration date, the same scenario applies. However, if the prices increase beyond the cap placed on the stock at the time of the option issuance, the buyer wins. In this situation the owner of the stock underperforms the market, but has still made a profit.
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In understanding covered calls, it is beneficial to understand as well what ex-dividend rate is. The ex dividend rate is a term used to describe the payment of dividends. Also referred to as the reinvestment date, it is the day two business days prior to the record date. The record date is the day a stock transaction is finalized. A dividend is a quantity of money due to a stockholder from the earnings of the company’s stocks. Generally there is a three day settlement period for stock transactions to finalize. Taking into account a dividend is payed on a set date, a trader interested in collecting the dividend payment for a particular stock must purchase the stock and have the transaction finalized three days before the dividend date, therefore timing the transaction so the record date and the dividend date coincide. This is important to know for you to remember when to cash in on your earnings. This is almost a sure thing when you use the covered call strategy.