Can a Covered Call Be Exercised Before Expiration?

Covered calls are a popular options strategy where an investor sells call options against shares of stock they already own. This approach generates income through the premium received, while the investor continues to hold the underlying shares. While options have a specific expiration date, a common question is whether a covered call can be exercised before its scheduled expiration. The answer is yes, under certain circumstances.

Understanding Early Exercise

Early exercise refers to an option holder converting their option contract into shares of the underlying stock before the official expiration date. This possibility exists only for “American-style” options, which comprise most equity options traded in the United States, including those used in covered calls. In contrast, “European-style” options can only be exercised on their expiration date.

The decision to exercise a call option early is made by the option buyer for specific financial reasons. One primary motivation is to capture an upcoming dividend payment from the underlying stock. Since option holders are not entitled to dividends, exercising the call before the ex-dividend date allows the buyer to become a shareholder and receive the dividend. Another reason for early exercise is when a call option is significantly “in-the-money,” meaning the stock price is well above the option’s strike price, and the option has very little time value remaining. The buyer might exercise to take immediate possession of the shares.

The Mechanics of Early Assignment

When an option buyer decides to exercise their American-style call option early, the process of “assignment” is initiated for the covered call writer. The Options Clearing Corporation (OCC), which acts as the central clearinghouse for options transactions, manages this process. The OCC receives the exercise notice from the buyer’s brokerage firm.

The OCC then randomly allocates this exercise notice among all brokerage firms that have clients with short (sold) positions in that specific option series. Once a brokerage firm receives an assignment notice from the OCC, it assigns it to one of its own clients who holds a short position in that option. This internal allocation by the broker can be random or based on a “first-in, first-out” (FIFO) method. Upon assignment, the covered call writer is notified by their broker. The writer is then obligated to sell their underlying shares at the option’s strike price to fulfill the contract.

Financial Implications of Early Assignment

Early assignment directly impacts the covered call writer’s financial outcome, as it accelerates the realization of profit or loss from the position. The overall profit on a covered call is determined by the premium received for selling the option, combined with the difference between the stock’s original purchase price and the strike price at which it is sold due to assignment. For instance, if shares bought at $50 are called away at a $55 strike price, and a $2 premium was received, the total gain would be the $5 per share capital appreciation plus the $2 premium.

The sale of shares due to early assignment is a taxable event, and the resulting gain or loss is subject to capital gains taxes. The tax rate applied depends on the holding period of the underlying stock. If the shares were held for one year or less prior to the assignment, any gain is classified as a short-term capital gain and taxed at ordinary income tax rates. If the underlying shares were held for more than one year, the gain is considered a long-term capital gain, which benefits from lower tax rates.

Early Assignment Versus Expiration

Understanding the distinction between early assignment and assignment at expiration is important for covered call writers. Both scenarios result in the underlying shares being sold at the strike price, but the timing and implications differ. If a covered call is in-the-money at expiration, meaning the stock price is above the strike price, the option will be exercised by the buyer, leading to assignment.

Early assignment occurs before the expiration date. The primary difference for the covered call writer is the forfeiture of any remaining time value in the option. If the option had significant time remaining until expiration, early exercise means the writer gives up that potential time decay, which would have reduced the option’s value. Conversely, if a covered call expires out-of-the-money, the option becomes worthless, and the writer keeps the entire premium collected without having their shares called away.