A covered call strategy is an investing strategy that involves selling call options. It’s the right to buy against stock that you already own or have recently purchased to generate additional income from those shares. The option you sell is "covered," because you own enough shares to cover the transaction as required by the option you’ve sold.
Covered call strategies help investors earn income, but they can also limit potential gains from increases in the price of a stock. Learn how a covered call strategy works and whether you should implement one.
Definition of a Covered Call Strategy
A covered call is used when an investor sells call options against stock they already own or have bought for the purpose of such a transaction. By selling the call option, you’re giving the buyer of the call option the right to buy the underlying shares at a given price and a given time. This strategy is “covered,” because you already own the stock that will be sold to the buyer of the call option when they exercise it.
- Alternate name: Writing covered calls
A covered call strategy involves two steps:
First, you have to buy shares of stock. You can select the stock using any method you prefer. As with any investment, it’s important to do your due diligence. Covered call strategies work well with stocks that have stable prices and aren’t volatile.
Second, you sell call options against the stock that you’ve purchased. Call options give the buyer the right, but not the obligation, to buy shares at a set price.
When you sell the option, the buyer has to pay you a premium; you get to keep it as income from selling the option. Each option contract typically involves 100 shares.
The premium that the buyer pays depends on multiple factors. The relationship between the share price and strike price of the stock, the expiration date of the option, and volatility in the share price of the stock are all taken into account.
How Does a Covered Call Strategy Work?
A covered call strategy is a popular options strategy. It's often considered low-risk, compared to others. It can help you generate income from your portfolio. Many brokerages will allow the selling of covered calls even in accounts that aren’t authorized to trade other options.
The reason covered calls are seen as low-risk is that the loss you can experience is limited. With some other options contracts, you can be exposed to theoretically infinite risk.
With a covered call, the worst-case scenarios are that you have to sell shares that you own; or, the shares you own lose all of their value less the premium you earned. In both cases, the potential loss is finite.
“Covered calls can be a great source of income, but you should always be ready to lose the underlying stock,” Henry Gorecki, CFP, told The Balance. “Think twice about writing calls on the stock of a great, growing company that you may want to hold on to for long-term appreciation.”
With a covered call strategy, you’re not just protecting yourself from losing money. You’re also placing a limit on how much you can earn from an increase in the stock’s price. In exchange, you receive income in the form of the premium paid by the option buyer.
Example of a Covered Call Strategy
Jane buys 100 shares in company XYZ at $50 each, for a total value of $5,000. She expects the share price to rise, and she sells one options contract with a strike price of $55 to Joe. Joe pays a premium of $20 for this call option.
If the share price doesn’t rise above $55, Joe is unlikely to exercise the option; it would then expire. When that happens, Jane gets to keep her shares and pocket the $20 Joe paid her. Her total profit or loss will be $20, plus or minus any changes in the price of XYZ from when she bought it $50 per share.
Jane’s best-case scenario here is that the stock rises in value to exactly $55 before the option expires, but Joe does not exercise his option. If this happens, she gets to keep the $20 she received from Joe and her shares, which are now worth a total of $5,500. Combined with the $20 she received from Joe, her total gain is $520.
The worst-case scenario is if XYZ’s shares become worthless. If that happens, Jane will lose her initial investment of $5,000. However, she gets to keep the $20 Joe paid her. That would put her total loss at $4,980.
If the option buyer doesn’t exercise the call option, and it expires, you can continue selling covered calls against the same shares, receiving additional premium payments.
If XYZ increases to $60 per share before the option expires, Joe can exercise the option. He’ll pay Jane $55 per share. Jane will then keep the $20 premium and receive $5,500 from Joe for her 100 shares. That would make her overall profit $5,520. However, she would lose out on potential profits, because she could have sold her shares for $60 each. She could have made $6,000 instead of just $5,500. But the call she sold to Joe forces her to settle for just $55 per share, plus the $20 premium.
Stock Ownership vs. Covered Calls
When you buy a stock, you accept the risk of the stock losing some or all of its value. The value of your investment increases as the stock price rises. While stock ownership is simple, in some cases selling a covered call may prove to be more profitable.
The below table shows how your investment gets impacted by stock price changes when you own a stock, compared with when you sell a covered call.
|Change in Stock Price||Result If You Own Just Stock||Result From Selling Covered Call||More Profitable Option|
|Increase above the strike price of the covered call||Profit equal to the increase in the stock’s price||You profit up to the strike price listed in the option, plus the premium, which together are less than the value of the investment based on actual share price. You also forgo any potential gains from future share price increases.||Owning just the stock|
|Increase, but remains below the strike price of the covered call||Profit equal to the increase in the stock’s price||Profit equal to the increase in the stock’s price, plus the premium, which together are higher than the value of the investment based on actual share price||Selling the covered call|
|No change||None||The premium received||Selling the covered call|
|Decrease||Loss equal to the decrease in the stock’s price||Loss equal to the decrease in the stock’s price, minus the premium||Selling the covered call|
Covered Calls and Taxes
One thing to watch out for with making money on covered calls is taxes. It may be a big drawback for some.
“Net gains and losses on covered calls are short-term capital gains and losses,” Gorecki said. “Short-term capital gains are taxed like ordinary income.” That means you could end up paying more in taxes than you would with long-term capital gains. But it’s not as simple as that. When an option gets exercised, Options Clearing Corporation (OCC), the options industry clearing house, randomly assigns the exercise notice to brokerage firms with a client account that has an equivalent option position. This process is called "assignment."
Once that happens, short-term or long-term capital gains or losses will be determined by the “strike price plus the premium received, as well as the cost basis and holding period of the underlying stock.”
Pros and Cons of Covered Calls
- Generate additional income from shares you own.
- Help you set a target selling price for stock you own.
- Losses are finite compared to other riskier options trading strategies.
- Limit your potential gains from any future stock price increases.
- Must continue owning the stock until your options expire.
- Net gains are subject to capital gains taxes.
- Generate additional income from shares you own: When you sell a covered call, you receive a premium payment from the buyer. If you want to earn income from your portfolio, this strategy can help you make money each time you sell a call.
- Help you set a target selling price for stock you own: Using covered calls allows you to target a selling price, higher than the current market price.
- Losses are finite, compared to other riskier options trading strategies: Even in the worst-case scenario, if the stock drops to $0, and the shares become worthless, the loss is finite, as opposed to other options strategies that may expose investors to infinite losses.
- Limit your potential gains from any future stock price increases: The most you can make when selling a covered call is the premium you receive, plus the difference between the strike price and the current price per share. If the price of that share increases above the strike price, you’ll still have to sell the shares at the strike price.
- Must continue owning the stock until your options expire: Sometimes, plans change, and you want to sell some of your investments. For a call to remain covered, you have to own the shares until the option expires, which might force you to hold the shares for longer than desired.
- Net gains are subject to capital gains taxes: You may have to pay short-term or long-term capital gains taxes based on a number of factors.
What It Means for Individual Investors
Selling covered calls is a popular strategy for long-term investors who want to generate extra income from their portfolios.
The key to success in covered call strategies is to pick the right company to sell the option on. Then, select the correct strike price.
Simple covered calls work best, so long as the price of a stock stays below the strike price of the contract. It also provides a slight limit on potential losses, as you can not lose the premium you receive from selling the option. The primary risk of the strategy is that you miss out on gains if the value of your investments jumps too quickly.
If you're ready to dip your toes into options trading, covered calls might be a good way to start. In some cases, selling a covered call may prove to be more profitable than owning the stock. But options trading is complicated; it's not for everyone. Weigh your risk appetite before making any decisions.
- Covered calls let you generate additional income from a portfolio of stocks.
- Covered calls are low-risk because you own the shares involved in the option.
- In the worst-case scenario, you lose out on potential gains past the strike price of the call contract.
- Covered calls are best for long-term investors who own shares in stable companies.
- Net gains from covered calls may be subject to capital gains tax.
The Balance does not provide tax, investment, or financial services or advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Investing involves risk, including the possible loss of principal.