A covered call is a stock trading strategy where you own 100 shares of a stock and sell a call option on those same shares. This lets you earn extra income from stocks you already own. Many investors use this strategy to boost their returns.
When you sell a covered call, you collect a premium payment upfront but agree to sell your shares at a specific price if the option buyer exercises their right. This works best when you think the stock price will stay flat or rise slightly. You keep the premium no matter what happens.
Understanding how covered calls work through real examples helps you see if this strategy fits your investing goals. The key is knowing when to use it and what risks come with it.
Key Takeaways
- Covered calls generate extra income by selling call options on stocks you already own
- You collect premium payments upfront but may have to sell your shares at the strike price
- This strategy works best when you expect the stock price to remain stable or increase moderately
What Is a Covered Call?
A covered call is an options strategy where you own 100 shares of stock and sell a call option on those same shares. This approach generates extra income from your stock position while limiting some upside potential.
Core Components of a Covered Call
A covered call requires two main parts. You must own at least 100 shares of the underlying stock. You also sell one call option contract against those shares.
The call option you sell has a specific strike price and expiration date. The strike price is the price at which the buyer can purchase your shares. Most covered calls use strike prices above the current stock price.
When you sell the call option, you receive a premium payment. This premium becomes immediate income for your portfolio. The amount depends on the stock price, strike price, time to expiration, and market conditions.
As the option writer, you have an obligation to sell your shares if the buyer exercises the contract. The option holder has the right to buy your shares at the strike price until expiration.
How the Strategy Works
You start by selecting stocks you already own or want to buy. Pick a call option with a strike price and expiration that fits your goals. Higher strike prices mean less premium but more room for stock gains.
After selling the call, you collect the premium right away. If the stock price stays below the strike price, the option expires worthless. You keep both the premium and your shares.
If the stock rises above the strike price, the buyer will likely exercise the option. You must sell your shares at the strike price. Your total return includes the premium plus any stock gains up to the strike price.
The strategy works best with stocks that move sideways or up slightly. Large price swings in either direction can reduce the effectiveness of covered calls.
Benefits and Drawbacks
Covered calls provide several advantages for investors. The main benefit is extra income from the option premium. This income can boost your returns, especially in flat markets.
The premium also offers some downside protection. If the stock drops, the premium reduces your losses by that amount. This makes the strategy less risky than owning stocks alone.
However, covered calls limit your upside potential. If the stock soars above the strike price, you miss out on those gains. You can only profit up to the strike price plus the premium received.
You also face the risk of having your shares called away. This forces you to sell at the strike price, which might create tax consequences. The timing of this sale is not under your control.
Step-By-Step Covered Call Example
This example shows how to pick a stock, sell a call option against your shares, and track the trade results. You’ll see exact numbers for profits and losses in different scenarios.
Choosing a Stock and Setting Up the Position
You own 100 shares of XYZ stock at $50 per share. This costs you $5,000 total. Your account shows these shares as a long position.
The stock pays quarterly dividends of $0.25 per share. This gives you $25 every three months in extra cash.
You pick XYZ because it trades steady with low risks. The stock price moves between $48 and $55 most days. This stability helps your covered call strategy work better.
Your position has upside potential if XYZ rises. But you want to earn extra money from the shares you already own. The call premium will add income to your returns.
Selling a Call Option: Details and Considerations
You sell one call option with a $55 strike price. The option expires in 30 days. You receive $2.00 per share in call premium.
This trade brings $200 cash into your account right away. You keep this money no matter what happens to XYZ stock.
The call buyer gets the right to buy your shares at $55. If XYZ stays below $55, the option expires worthless. You keep your shares and the $200 premium.
If XYZ goes above $55, you must sell your shares at that price. Your maximum profit is $200 premium plus $500 gains from $50 to $55. This equals $700 total.
The downside protection is limited. You only get $200 to offset losses if XYZ falls.
Monitoring Outcomes: Profits, Losses, and Adjustments
Scenario 1: XYZ closes at $52 after 30 days. The call expires worthless. You keep your shares and earned $200 premium. Your total return is $200 plus any dividends.
Scenario 2: XYZ rises to $58. The call buyer exercises their right. You sell your shares for $5,500 and keep the $200 premium. Your profit is $700 total.
Scenario 3: XYZ drops to $45. You lose $500 on your shares but keep the $200 premium. Your net loss is $300.
You can roll the position by buying back the call early. This costs money but lets you sell another call with a different strike price or date.
Tax considerations affect your outcomes. The call premium counts as short-term gains. If your shares get called away, the sale creates capital gains or losses based on your original purchase price.
