A covered call is an options strategy where you own 100 shares of stock and sell a call option against those shares. This approach lets you collect extra income from your stock holdings while keeping ownership of the shares. Many investors use this strategy to boost returns on stocks they already own.
The covered call strategy generates immediate income through option premiums while allowing you to keep your stock dividends and potential price gains up to the strike price. You pick a strike price above your stock’s current value and collect money upfront when you sell the call. If the stock stays below that price, you keep both the premium and your shares.
This strategy works best when you expect your stock to stay flat or rise slowly. You give up some upside potential in exchange for guaranteed income today. Understanding when and how to use covered calls can help you make better decisions with your investment portfolio.
Key Takeaways
- Covered calls generate immediate income by selling call options against stocks you already own
- You keep all profits if the stock price stays below your chosen strike price at expiration
- The strategy limits your upside potential but provides steady income and downside protection
Covered Calls Explained
A covered call strategy is one of the most basic options strategies you can use. You own stocks and sell call options on those same stocks.
When you sell a call option, you create a contract with another investor. This contract gives them the right to buy your stocks at a set price.
Here’s how it works:
- You own 100 shares of stock
- You sell one call option contract
- Each contract covers 100 shares
The buyer pays you money upfront for this right. This payment is called a premium. You keep this money no matter what happens.
If the stock price stays below the strike price, the option expires worthless. You keep your stocks and the premium you received.
If the stock price goes above the strike price, the buyer might exercise their option. This means you must sell your stocks at the agreed price.
Key benefits of this options trading strategy:
- Generate extra income from stocks you own
- Reduce risk slightly through premium income
- Simple to understand and execute
This call options strategy works best when you think your stocks will stay flat or rise slowly. Many investors use covered calls to boost returns on stocks they plan to hold long-term.
The term “covered” means you own the underlying stocks. This makes it safer than selling call options without owning the stocks.
How Covered Calls Work
You start by owning 100 shares of a stock. This is your stock position. Then you sell a call option on those shares.
The call option has a strike price. This is the price where the buyer can purchase your shares. You pick this strike price when you sell the option.
When you sell the call option, you receive a premium. This is money you get right away. The premium is yours to keep no matter what happens.
Here’s a simple example: You own 100 shares of XYZ stock at $50 per share. You sell a call option with a $55 strike price. You receive a $2 premium per share, which equals $200 total.
If the stock price stays below $55, nothing happens. You keep your shares and the $200 premium. If the stock price goes above $55, the buyer will likely exercise the option.
When the option gets exercised, you must sell your 100 shares at the strike price. In our example, you would sell at $55 per share even if the current stock price is higher.
Premiums change based on several factors. Time until expiration affects the premium. The difference between the current stock price and the strike also matters. More volatile stocks usually have higher premiums.
You can repeat this process each month with new options. This creates regular income from the premiums you collect.
Where Do You Sell The Call?
You sell the call option through your brokerage account. Most online brokers let you trade options on their platforms.
Popular Places to Trade:
- Online brokerage accounts
- Trading apps
- Full-service brokers
You need approval for options trading first. Your broker will ask about your experience and risk level.
The ask price is what you receive when you sell the call. This becomes income for you right away.
You want to pick a strike price above your stock’s current price. If your stock costs $50, you might sell a call at $55.
Strike Price Tips:
- Higher strikes = less money but safer
- Lower strikes = more money but riskier
The time until the option expires affects rates too. Longer times mean more premium income.
You keep the money from selling the call no matter what happens. This helps offset any stock losses.
When the trade works best:
- Stock prices stay flat or rise slowly
- You bought the stock below current price
- The premium covers part of your purchase price
Most traders sell calls that expire in 30-45 days. This gives good income without tying up your stock too long.
Remember that selling calls limits your stock gains. If the stock jumps above your strike price, you miss those extra profits.
The Biggest Mistakes
Not understanding the risk is the top mistake. You can still lose money if the stock price drops sharply.
Many investors think covered calls are safe. This is wrong. You face the same downside risk as owning the stock alone.
Picking the wrong strike price limits your profits. Set it too low and you miss out on appreciation. Set it too high and you get less premium.
Writing calls on volatile stocks without planning creates problems. High volatility means bigger price swings. Your stock might get called away quickly.
Here are common timing mistakes:
- Writing calls right before earnings
- Not checking ex-dividend dates
- Holding through major news events
Forgetting about taxes hurts your real gains. Short-term profits from premiums get taxed at higher rates.
Not having an exit plan leads to poor choices. Know when to buy back the call or let it expire.
Chasing high premiums often means taking on too much risk. Those big premiums usually come with good reasons.
Some investors write calls on stocks they don’t want to sell. This creates emotional stress when the stock gets called away. Only use this strategy on stocks you’re willing to part with.
Ignoring transaction costs eats into profit. Multiple trades add up over time. Factor in commissions and fees when calculating your potential gain.
The biggest mistake is treating covered calls like guaranteed income. Market conditions change. Your losses can be much larger than the premium you collect.
What Happens When You Get Assigned
Assignment happens when the call buyer decides to exercise their right to buy your shares. This usually occurs when the stock price is above your strike price.
As the call writer, you must sell your 100 shares to the buyer. The sale happens at the strike price you agreed to when you sold the call.
When Assignment Typically Occurs:
- Stock price is above strike price at expiration
- Buyer exercises their right early
- High dividend payments are coming
You keep all the premium you collected from selling the call. This money is yours regardless of assignment.
The buyer pays you the strike price for your shares. If you owned the stock below this price, you still make a profit.
Assignment Process:
- Buyer exercises the call option
- Your broker gets notified
- Your shares are sold automatically
- You receive the strike price payment
Assignment can happen any time before expiration. However, it’s most common near expiration when the stock trades above your strike price.
You cannot avoid assignment once the buyer decides to exercise. As the seller, you have an obligation to deliver the shares.
After assignment, your covered call position closes. You no longer own the stock or have the call obligation.
Should You Sell Covered Calls?
Covered calls work best when you own stocks in your portfolio that you don’t mind selling. This strategy fits well in regular investment accounts and IRAs.
Your account type matters. You can sell covered calls in most investment accounts. IRAs allow covered calls since you already own the underlying stock.
Consider covered calls when you want extra cash from your investments. The premium you collect goes straight to your account balance.
Market conditions affect your success. Covered calls work well in flat or slightly rising markets. You keep the premium and your stock position if the stock price stays below your strike price.
Your investment goals should match this strategy. Covered calls generate income but limit your upside potential. If you expect big gains from your stocks, this might not fit your plan.
Risk tolerance is key. You must be comfortable selling your stock at the strike price. Some investors use covered calls on positions they plan to hold long-term.
The bottom line depends on your situation. New investors should start small and learn how options work first. Experience with your portfolio helps you pick the right stocks and strike prices.
Consider these factors:
- How long you plan to hold the stock
- Your need for extra income
- Market outlook for your positions
- Tax implications in your account type
Practice with small positions before making covered calls a major part of your investment strategy.
