What Is a Covered Call?
A covered call is one of the most popular options trading strategies used by investors who own shares of a stock and want to generate additional income. In this strategy, you sell (write) a call option against shares you already hold, collecting the option premium as income. The strategy is called "covered" because your stock ownership covers the obligation to deliver shares if the option buyer exercises the contract.
Covered calls are considered a conservative options strategy because you already own the underlying shares. This makes them suitable for investors who have a neutral to moderately bullish outlook on a stock and want to generate income while they hold their position.
When you sell a covered call, you give someone else the right to buy your shares at the strike price before the expiration date. In exchange, you receive the option premium as immediate income.
How to Calculate Covered Call Returns
Understanding how to calculate covered call returns is essential for evaluating whether a particular covered call trade is worth pursuing. There are several key metrics you need to calculate: maximum profit, breakeven price, static return, and if-called return.
- 1Total premium income = $3.50 × 100 shares = $350
- 2Capital gain if called = ($105 - $98) × 100 = $700
- 3Maximum profit = $350 + $700 = $1,050
- 4Maximum return = $1,050 / ($98 × 100) = 10.71%
- 5Breakeven price = $98 - $3.50 = $94.50
- 6Downside protection = $3.50 / $100 = 3.50%
When to Use a Covered Call Strategy
Covered calls work best in specific market conditions and when you have the right investment objectives. Understanding when to use this strategy can significantly improve your results.
- You have a neutral to slightly bullish outlook on the stock
- You want to generate income from shares you already own
- You are willing to sell your shares at the strike price if the option is exercised
- You want to reduce your cost basis over time through premium collection
- You are looking for a lower-risk way to begin options trading
- The stock has moderate implied volatility (higher premiums without excessive risk)
Covered Call Outcomes: What Can Happen
| Scenario | Stock Outcome | Option Outcome | Your Result |
|---|---|---|---|
| Stock rises above strike | Shares called away at strike price | Option exercised, you keep premium | Premium income + capital gain (capped at strike) |
| Stock stays near current price | You keep shares | Option expires worthless | Keep premium as pure income |
| Stock drops slightly | Shares decline in value | Option expires worthless | Premium cushions some of the loss |
| Stock drops significantly | Large unrealized loss on shares | Option expires worthless | Premium provides limited protection |
Covered Call vs. Other Options Strategies
The covered call is often compared to other income-generating strategies. Unlike a naked call (which carries unlimited risk), a covered call has defined risk since you own the underlying shares. Compared to a cash-secured put, a covered call is used when you already own shares, while a cash-secured put is used when you want to buy shares at a discount.
The poor man's covered call (PMCC) is a variation that uses a deep-in-the-money LEAPS option instead of shares, requiring significantly less capital. However, it also has different risk characteristics and may not be suitable for all investors.
Tips for Successful Covered Call Writing
Best Practices for Covered Calls
Tax Implications of Covered Calls
In the United States, covered call premiums are generally taxed as short-term capital gains, regardless of how long you have held the underlying stock. If the call expires worthless, the premium is recognized as a short-term gain in the year of expiration. If the option is exercised, the premium is added to the sale price of the shares, which may affect whether your stock gain is short-term or long-term.
Writing in-the-money covered calls can suspend the holding period for long-term capital gains treatment on your stock. Always consult a qualified tax professional for advice specific to your situation.