What Are Covered Calls?
A covered call is an options trading strategy where you sell (write) a call option against shares of stock you already own. The word 'covered' means your obligation to potentially deliver shares is covered by your existing stock position. In exchange for selling the call, you receive an immediate cash payment called the option premium. This premium is yours to keep regardless of what happens to the stock or the option.
Covered calls are one of the most conservative and popular options strategies in the world. They are used by individual investors, portfolio managers, pension funds, and endowments to generate income from stock positions. If you own 100 shares of any optionable stock, you can write one covered call contract.
How Covered Calls Work: A Simple Explanation
Imagine you own 100 shares of a stock trading at $50. You sell a call option with a $55 strike price for $1.50 per share. You immediately receive $150 ($1.50 x 100 shares). Now there are three possible outcomes at expiration: (1) The stock stays below $55 - the option expires worthless, you keep the $150 and your shares. (2) The stock rises above $55 - your shares are sold at $55, and you keep the $150 premium plus any gain up to $55. (3) The stock drops - you keep the $150, which cushions some of the loss on your stock.
Covered Call Terminology
- Strike Price: The price at which the call buyer can purchase your shares
- Premium: The cash payment you receive for selling the call option
- Expiration Date: When the option contract expires (typically monthly)
- Exercise/Assignment: When the call buyer uses their right to buy your shares
- In-the-Money (ITM): The stock price is above the call strike price
- Out-of-the-Money (OTM): The stock price is below the call strike price
- At-the-Money (ATM): The stock price equals the call strike price
A Simple Covered Call Example
- 1You own 100 shares at $50 = $5,000 position
- 2You sell 1 call contract at $55 strike for $1.50
- 3You receive $150 immediately (premium income)
- 4If stock stays at $50: You keep $150 + shares = 3% return in 30 days
- 5If stock rises to $60: Shares sold at $55, total income = $55 - $50 + $1.50 = $6.50/share = $650
- 6If stock drops to $45: Stock loss = -$500, but premium offsets $150, net loss = -$350
Why Use Covered Calls?
| Advantages | Disadvantages |
|---|---|
| Generate income from stocks you own | Upside is capped at the strike price |
| Lower your cost basis over time | Does not fully protect against large declines |
| Reduce portfolio volatility | Premium income is taxed as short-term gains |
| Easy to understand and execute | Requires options approval from your broker |
| Works in flat and slightly bullish markets | You may need to sell shares you want to keep |
Covered calls are ideal for investors who own stocks they are comfortable holding long-term, want additional income beyond dividends, have a neutral to moderately bullish outlook, and are willing to sell shares at a profit if the stock rises above the strike price.