Covered calls generate premium income from stocks you already own. Learn how the strategy works (with a step-by-step example) and understand the risks and downsides before you start.
What is a covered call?
A covered call is an options contract that investors can sell to generate income from the securities they own. The two components of the name describe the contract’s primary characteristics:
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Call: An investor who sells a call option must, upon request and prior to the contract expiration, sell securities at an agreed price. The option seller, called the writer, collects a nonrefundable premium from the buyer, who pays for the right to buy the securities. Option buyers are called holders.
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Covered: Covered indicates the option writer owns the underlying securities. If the writer does not own the underlying securities, the option is called a “naked” call. Importantly, the distinction between covered and naked is on the writer’s side. The option buyer does not know whether the contract is collateralized. For that reason, covered calls are usually defined and discussed from the writer’s perspective.
Writers typically sell covered calls to generate income or to secure a target selling price for the stock. When income is the goal, the option can be structured so it’s less likely to be exercised. If the holder does not exercise the right to buy the shares, the option expires without value. The writer then keeps the underlying shares and the premium earned for selling the contract.
If a targeted sale is the goal, the writer sets a realistic strike price, hoping to earn income and sell the security as part of the same strategy.
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How a covered call works, step by step
These are the mechanics of placing and filling a covered call.
The writer chooses a security
The writer usually chooses a stock and researches its available options, noting the strike prices, expiration dates, and premiums. The strike price is the per-share amount at which the holder can buy the stock.
The writer decides on a strike price and expiration date
The writer weighs the income opportunity against the desired outcome. A lower strike price generates more income but increases the chances the option will be exercised.
The writer places the order to sell
The order can be a “buy-write” if the writer wants to purchase the stock while setting up the covered call. Or it’s an “overwrite” order if the writer already owns the shares. The market sets the option premium based on the terms.
When the order is filled, the holder pays the premium, and the writer collects it.
Once the contract is in place, the price movements of the underlying stock relative to the strike price determine what happens next:
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The stock can rise above the strike price, and the options contract will increase in value. The writer can buy back the contract or wait for the holder to exercise it. American-style options can be exercised at any time before expiration, while European-style options are exercised only at expiration. When a holder exercises an option, the Options Clearing Corporation randomly assigns a writer of the same contract to fulfill it. The assigned writer must deliver shares for the strike price.
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The stock can remain at or below the strike price. In this case, the option will gradually lose value as the expiration date approaches. If the option expires without value, the writer keeps the premium and the shares.
Covered call example
Covered calls risks and downsides
Selling covered calls can affect your investing flexibility, gain potential, and tax bill.
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Less flexibility. You cannot sell the shares you use to back a covered call unless you are assigned or the contract expires. This limitation may prevent you from liquidating to take advantage of better opportunities. Also, in the case of an assignment, you may be obligated to sell at a below-market price.
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Lower gain potential. Selling covered calls limits your upside on a position. You will not benefit from any price appreciation above the strike price.
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Tax risk. Fulfilling covered calls can result in taxable gains on the shares sold. A higher tax bill reduces the net benefit of the premium income earned.
Covered calls vs. cash-secured puts
Covered calls are related to another type of collateralized options strategy called cash-secured puts. The table below highlights the differences between the two.
Is a covered call good for beginners?
Covered calls are complex enough to present real challenges for beginners. The strategy can produce income, but it can also derail a long-term investing plan by locking up collateral shares or forcing early liquidations. Additionally, the potential tax consequences could be significant enough to outweigh the benefit of the earned premium income.
Beginners can benefit from practice without capital through paper or virtual trading. The experience without loss exposure can highlight the complexity of predicting a security’s movements accurately. Trading simulators are available online and from brokers like Charles Schwab.
Covered calls FAQs
How does a covered call work?
Option writers sell covered calls on stocks they own to generate income from their portfolio. The goal is to sell calls that won’t be exercised, so the writer keeps the premium and the shares. If the calls are exercised, the writer must deliver the shares at the strike price — forgoing gains above the strike price.
What is the downside to covered calls?
Shares that back call options cannot be traded outside of the contract, which limits the writer’s investing flexibility. Also, if the market price of the underlying security moves above the strike price, the writer may have to sell the position at a price below the current market value. The sale transaction may result in taxable gains, which can reduce the net benefit of the premium earned for selling the option.
Can you really make money with covered calls?
Selling covered calls does generate premium income, which the option writer keeps regardless of the underlying stock’s performance. Depending on contract terms, however, the premium income may not justify the risks of higher taxes and forgone capital gains.
