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How Covered Calls Work: A Complete Guide to This Popular Options Strategy

Learn what covered calls are, how they work in general and how can you earn income on the stock you already own by doing this strategy. You can also learn about the risks and best practices to optimize this strategy for your investment goals and market conditions.

    Highlights
  • Covered calls generate income by selling call options on stocks you own
  • Covered calls generate income by selling call options on stocks you own
  • This strategy works best in neutral to slightly bullish market conditions

So, how covered calls work?
In short, they let you earn extra income from stocks you already own.
You do that by selling a call option on shares you hold, collecting premium payments. With this strategy you are still owning the stock so you’re keeping your stock dividends.
This strategy works best when you think your stock price will stay flat or rise slightly.

Many investors use covered calls to boost their returns during sideways markets.
You keep the premium money no matter what happens to the stock price.
However, you might miss out on big gains if your stock shoots up past the strike price.

This options strategy gives you more control over your investments. You can choose which stocks to use and set your own strike prices. The key is understanding when covered calls make sense for your portfolio.

Understanding How Covered Calls Work

A covered call involves owning stock and selling call options against those shares to collect premium income. You take on the obligation to sell your stock at a specific price if the buyer exercises the option.

Definition and Key Concepts

A covered call is an options strategy where you own at least 100 shares of stock and sell a call option on those shares. The “covered” part means you already own the underlying asset.

When you sell the call option, you collect premium from the buyer. This premium is yours to keep regardless of what happens to the stock price.

The call option has two key parts: the strike price and expiration date. The strike price is the price at which you agree to sell your shares. The expiration date is when the contract ends.

Each options contract covers 100 shares of stock. If you own 500 shares, you can sell up to 5 covered call contracts.

Mechanics of a Covered Call Trade

You start by owning shares in your account. Then you sell a call option with a strike price above the current stock price.

The buyer pays you premium for the right to buy your shares at the strike price. This premium goes into your account immediately.

If the stock price stays below the strike price by expiration, the option expires worthless. You keep your shares and the premium.

If the stock price goes above the strike price, the buyer will likely exercise the option. You must sell your 100 shares at the strike price per contract.

Role of the Covered Call Seller and Buyer

As the seller, you collect premium income from the trade. You also limit your upside profit potential because you must sell at the strike price if called away.

You have the obligation to deliver shares if the buyer exercises the option. This obligation lasts until expiration or until you buy back the option.

The buyer pays premium for the right to purchase your shares. They benefit if the stock price rises above the strike price plus the premium they paid.

The buyer has no obligation and can choose whether to exercise the option. Most investors exercise when the stock price exceeds the strike price.

Benefits, Risks, and Key Considerations

Covered calls offer steady income generation but limit your upside potential while providing minimal downside protection. Understanding the trade-offs between premium collection and profit limitations helps you determine if this strategy fits your investment goals.

Potential Advantages and Income Generation

Covered calls generate regular income through premium collection. You receive money upfront when you sell the call option against your stock position.

This income reduces your cost basis in the stock. For example, if you own 100 shares at $50 each and collect $200 in premium, your effective cost drops to $48 per share.

Key income benefits include:

  • Monthly or weekly premium collection
  • Enhanced returns on flat or slowly rising stocks
  • Tax advantages in retirement accounts like IRAs

The premium income works well in sideways markets. When your stock trades in a narrow range, you keep collecting premiums while your shares remain unchanged.

You can repeat this process multiple times per year. Each expiration gives you a chance to sell another call and collect more premium.

Risks and Downside Protection

Covered calls provide limited downside protection. The premium you collect only cushions small losses, not major market declines.

Your main risk is capping upside gains. If your stock price jumps above the strike price, you miss out on profits beyond that level.

Major risks include:

  • Opportunity cost: Missing large price increases
  • Assignment risk: Losing your shares if called away
  • Limited hedge: Premium doesn’t protect against big losses

Consider a stock that rises from $50 to $70. With a $55 call, you only profit up to $55 plus the premium collected. You lose $15 per share in potential gains.

Downside protection remains minimal. If your stock drops from $50 to $40, a $2 premium only reduces your loss from $10 to $8 per share.

Best Practices for Covered Call Strategies

Choose stocks you don’t mind selling. Only write calls on positions you’re willing to lose if assigned.

Target strike prices 5-10% above current stock value. This balance provides decent premium while allowing some upside participation.

Effective practices:

  • Sell calls with 30-45 days to expiration
  • Avoid calls during earnings announcements
  • Roll options before assignment if needed
  • Focus on high-dividend stocks for extra income

Monitor your positions regularly. You can buy back calls early if the stock drops significantly, then sell new calls at lower strikes.

Consider the tax impact in taxable accounts. Called shares create taxable events, while IRA trading avoids immediate tax consequences.

Diversify across multiple positions. Don’t concentrate covered call writing in just one or two stocks to reduce single-stock risk.

Covered calls can provide regular income through premiums, but the amount varies.
Premium income depends on stock price movement, market conditions, and time until expiration.

Some months you may earn higher premiums when market volatility increases.
Other months may offer lower premiums when markets are calm.

Your shares may get called away, forcing you to find new stocks for future covered calls.
This can disrupt your income stream temporarily.

Your biggest risk is missing out on large stock gains.
If the stock price jumps well above your strike price, you still only get the strike price when your shares are called away.

You can lose money if the stock price drops significantly.
The premium you collected only provides limited protection against falling stock prices.

You cannot sell your shares while the call option is active without first buying back the option.
This limits your flexibility to exit the position quickly.

You need to own 100 shares of stock for each covered call contract you write.
The stock acts as collateral for the call option you sell to another investor.

You collect a premium when you sell the call option.
This premium is yours to keep regardless of what happens to the stock price.

You choose a strike price above the current stock price.
You also pick an expiration date, typically 30 to 45 days away.

If the stock price stays below the strike price at expiration, you keep your shares and the premium.
If the stock price goes above the strike price, you must sell your shares at the strike price.

Choose stocks you would be comfortable owning long-term.
Avoid stocks you expect to rise sharply in the near future.

Look for stocks with high option volume and tight bid-ask spreads.
This makes it easier to enter and exit positions at fair prices.

Pick stocks that pay dividends if possible.
You collect dividend income in addition to option premiums while you own the shares.

Avoid stocks with upcoming earnings announcements or major events.
These can cause large price swings that work against your position.

Option premiums you collect are taxed as short-term capital gains. You pay your regular income tax rate on this money.

If your shares get called away at a profit, you pay capital gains tax on the stock sale. The tax rate depends on how long you owned the shares.

If you owned the shares for more than one year, you pay long-term capital gains rates. Shares owned for less than one year face short-term capital gains rates.

You can deduct losses if your shares lose value. Always consult a tax professional for your specific situation.

A covered call involves owning stock and selling call options against those shares.
You profit from premiums and potential stock appreciation up to the strike price.

A covered put involves being short stock and selling put options.
You must have enough cash to buy shares if the put gets assigned.

Covered calls work well in neutral to slightly bullish markets.
Covered puts work better in neutral to slightly bearish markets.

Most investors find covered calls easier to understand and execute than covered puts.