So, what are covered calls?
A covered call is an options strategy where you sell call options on stocks you already own to generate extra income. This popular investment approach lets you earn money from your existing stock holdings while potentially limiting some upside gains.
Many investors use covered calls to create steady income from their portfolios. The strategy works best when you expect your stocks to stay flat or rise slightly over the short term.
You might wonder if covered calls are right for your investment goals. Understanding how they work and their risks can help you decide whether to add this strategy to your portfolio.
Understanding Covered Calls
Covered calls combine stock ownership with option selling to generate additional income from your existing stock positions. This strategy involves specific components and creates obligations for both buyers and sellers in the options market.
Definition of Covered Calls
A covered call is an options strategy where you own shares of stock and sell call options on those same shares. You must own at least 100 shares for each call option contract you write.
The strategy gets its name because your stock position “covers” the call option you sell. If the buyer exercises the option, you already own the shares to deliver.
This approach differs from naked call writing. With naked calls, you sell call options without owning the underlying stock. Covered calls are less risky because you hold the actual shares.
How Covered Calls Work
When you write a covered call, you receive premium payment from the buyer immediately. This premium becomes yours to keep regardless of what happens to the option.
You collect this income while still owning your stock position. The premium provides a buffer against small stock price declines.
If the stock price stays below the strike price at expiration, the option expires worthless. You keep both the premium and your shares.
If the stock price rises above the strike price, the buyer may exercise the option. You must sell your shares at the agreed strike price.
Key Components: Underlying Asset, Strike Price, Expiration
Every covered call involves three essential elements that determine the strategy’s outcome.
The underlying asset is the stock you own in your portfolio. You need exactly 100 shares per options contract you plan to sell.
The strike price is the price at which you agree to sell your shares if exercised. You choose this price when writing the call option.
The expiration date sets when the option contract ends. Most investors use monthly expirations, though weekly options are available for many stocks.
These components work together to define your potential profit and loss scenarios. Higher strike prices typically generate less premium but allow more upside participation.
Roles of Buyer and Seller
As the covered call seller, you have specific obligations throughout the contract period. You must be ready to deliver your shares if assigned.
The call buyer pays you premium for the right to purchase your shares. They can exercise this right anytime before expiration if the option is in-the-money.
You cannot control when assignment occurs. The buyer makes this decision based on their investment goals and market conditions.
Your role requires maintaining the stock position until the option expires or gets assigned. Selling the underlying shares early would convert your position to a naked call.
Key Benefits, Risks, and Strategies for Investors
Covered calls provide regular income through premium collection but limit your upside potential if stocks rise above the strike price. Understanding the tax implications, fees, and timing helps you make better trading decisions.
Income Generation and Premium Collection
When you sell covered calls, you collect cash upfront from the premium. This money goes directly into your account regardless of what happens to the stock price.
The income works especially well in flat or slowly rising markets. You keep the premium if the stock stays below your strike price. Many traders use this strategy to boost returns on stocks they already own.
Premium amounts depend on several factors:
- Stock volatility
- Time until expiration
- Distance between current price and strike price
- Market conditions
You can repeat this process monthly or quarterly. Each time you sell a new call, you collect another premium. This creates a steady income stream from your stock positions.
Some investors target stocks that pay dividends too. You collect both the dividend and the call premium. This combination increases your total returns from the position.
Risks and Downsides of Covered Calls
Your biggest risk is missing out on large gains. If your stock jumps above the strike price, you must sell at that lower price.
Example: You own stock at $50 and sell a $55 call for $2. If the stock rises to $70, you only get $55 plus the $2 premium. You miss the extra $15 in gains.
The downside protection is limited. The premium only covers small losses. If your stock drops from $50 to $30, the $2 premium doesn’t help much.
You also face assignment risk. The buyer can force you to sell your shares at any time before expiration. This usually happens when the stock price rises well above your strike price.
Other potential downsides include:
- Brokerage fees for each trade
- Tax complications from frequent trading
- Time spent managing positions
- Possibility of losing shares you wanted to keep long-term
When to Use a Covered Call Strategy
Use covered calls when you expect your stock to stay flat or rise slowly. This strategy works best in sideways markets.
Good candidates are stocks you don’t mind selling. Avoid using this strategy on your favorite long-term holdings. You might lose them if the price jumps.
Ideal situations include:
- Stocks trading in a range
- High volatility that increases premium values
- Positions where you want extra income
- Stocks approaching resistance levels
Consider your target price before selling calls. Pick a strike price you’d be happy to sell at. Don’t get greedy with strikes that are too high.
The strategy also works well in IRAs. You avoid some tax complications while generating income. Many funds and brokerage products use covered calls for this reason.
Avoid covered calls right before earnings or major news. These events can cause big price moves. You might miss large gains or face unexpected assignment.
Tax Implications and Common Costs
Short-term capital gains rates apply to most covered call profits. These rates are higher than long-term rates. The premium you collect gets taxed as ordinary income.
Common costs include:
- Commission fees for selling calls (typically $0.50-$1.00 per contract)
- Assignment fees if your shares get called away
- Bid-ask spreads that reduce your premium
- Potential wash sale rule complications
If you hold stocks for over a year, selling calls can reset your holding period. This means you lose long-term capital gains treatment. Research the tax rules carefully or ask a professional.
Your brokerage will send you tax forms showing all options trading activity. Keep good records of your trades. Note the dates, prices, and reasons for each position.
Banking regulations treat options differently in retirement accounts. Some IRAs don’t allow covered calls. Check with your provider before trading. The fees and tax benefits vary by account type.
Information about tax rates changes frequently. Current rates and rules might not apply next year. Always verify the latest tax information before making trading decisions.
