I’m often asked, “what are stock options?” by some of my newer readers. Stock options are derivatives based on the value of the stock and offer the trader the opportunity to buy or sell the stock at a stated price within a specific time. The most common option trades, especially for beginners, are covered calls.

Covered call trades, or selling call options, is an excellent tool for conservative investors. As an option seller, you get to play the house to the gamblers who use options to speculate. Selling calls can add a serious income boost to your portfolio; however, I find many of the investors with whom I communicate want to use option selling in ways that could be a serious detriment to their wealth.

A covered call trade involves selling call options against shares you own. The shares provide the underlying asset should the options be exercised. Each call option comes with a strike price and an expiration date.

The typical trade involves selling calls with a strike price above the current share price. If the stock price is below the strike price at expiration, you keep the cash from selling the calls and retain the shares. If the stock price exceeds the call strike price at expiration, the option will automatically exercise, and the shares will be “called away.” You will receive the strike price for the shares.

A covered call trade generates income from the sold call premium or price. You keep the option premium no matter the outcome of the trade. If the trade is appropriately set up, an additional small capital gain will be earned if the shares are called away. If the option is not exercised, you can sell more calls for more income backed by the shares you own.

I hope that gets across how covered call trades make money. There is tremendous nuance and strategy to using covered calls. Twice a year, we offer a five-day webinar series to get those who are new to this strategy up to speed to do it right.

Which leads me back to where those investor conversations I have, and all the times I’ve heard about inappropriate uses of the covered call strategy.

The most common misuse of call selling occurs when investors want to sell calls backed by the shares they already own in their long-term investment portfolios. The rationale for selling calls against long-held shares is that the call premium adds some extra income from the portfolio and provides some downside cushion if the share price of the underlying stock declines. The reality is that using call selling in this scenario fails to meet either of those goals adequately. The amount of option premium earned does not offset the potential losses from either a stock that jumps higher or experiences a steep decline.

The second mistake I see is traders choosing stocks that are inappropriate for covered call trading. If you want to trade covered calls on stocks with no earnings and overvalued share prices, the results are bound to disappoint. You might find a very rich, very attractive option premium to sell with this type of stock; however, this is also the type of stock that can go down and stay down on just a bit of bad news.

Successful and profitable covered call trading requires finding that middle ground. You need to dig out stocks backed by stable businesses and sport attractive call premium levels. For my covered call service, Weekly Income Accelerator, I look for stocks where the option premium generates about 2% per month in cash flow with another 4% to 5% upside to the strike price.