How Does a Covered Call Work? A Breakdown of the Strategy

A covered call is an options strategy where an investor sells call options against shares of stock they already own. This strategy aims to generate additional income from premiums. This approach is often attractive to investors who hold a neutral to moderately bullish view on their stock, expecting its price not to increase significantly in the near term.

Understanding the Components

A call option contract grants the buyer the right, but not the obligation, to purchase an underlying asset at a specified price within a defined timeframe. Contracts are standardized, typically representing 100 shares of the underlying stock. For a covered call, the investor must already own the specific shares of the underlying stock that the option contract references, which is what makes the call “covered.”

The strike price is the predetermined price at which the option holder can buy the shares if they choose to exercise the option. This price remains constant throughout the option’s life. The expiration date marks the final day the option contract is valid.

The premium is the income the seller of the option receives from the buyer for granting the right to purchase the shares, and this payment is the primary motivation for implementing a covered call strategy. It is typically quoted on a per-share basis, so for a standard 100-share contract, the total premium received is 100 times the quoted premium.

The Mechanics of a Covered Call

Establishing a covered call involves an investor selling a call option for shares they already possess. This action obligates the investor, as the option seller, to potentially sell their shares at the predetermined strike price if the option buyer chooses to exercise their right.

Upon selling the call option, the investor immediately receives the premium, which is deposited into their brokerage account. The investor retains ownership of the shares and continues to receive dividends until the option is exercised or expires.

Consider an example: an investor owns 100 shares of Company A stock, purchased at $50 per share. They decide to sell one call option contract with a strike price of $55, expiring in one month, and receive a premium of $2.00 per share. The total premium collected is $200 (100 shares $2.00). The investor now has the obligation to sell their 100 shares at $55 each if the option is exercised, but they have also generated $200 in immediate income.

This strategy caps the investor’s potential upside profit on the stock at the strike price plus the premium received, as they are obligated to sell at that price. The premium also provides a limited buffer against potential losses if the stock price declines.

Potential Scenarios and Returns

The outcome of a covered call strategy depends on the underlying stock’s price relative to the option’s strike price at expiration. If the stock price remains below the strike price at expiration, the call option will typically expire worthless. In this instance, the option buyer will not exercise their right to purchase the shares, as they can buy them at a lower price in the open market. The investor retains their shares and keeps the premium, generating income from their holdings. For example, if the investor from the previous example owned shares at $50, sold a $55 call for $2.00, and the stock closed at $53 at expiration, the option expires worthless. The investor keeps the $200 premium and their 100 shares, effectively reducing their cost basis to $48 per share ($50 – $2).

Conversely, if the stock price rises above the strike price at expiration, the option will likely be exercised, leading to assignment. This means the investor is obligated to sell their 100 shares at the strike price to the option buyer. The investor’s profit in this scenario includes the premium received plus any appreciation of the stock up to the strike price. Using the same example, if the stock price closed at $57 at expiration, the option would be exercised. The investor sells their 100 shares at $55 each, receiving $5,500. Their total profit would be the $500 gain on the stock ($55 strike – $50 purchase price) plus the $200 premium, for a total of $700.

If the stock price is at or near the strike price at expiration, the outcome can vary. Generally, if the stock closes slightly above the strike price, the option will be exercised. The maximum profit for a covered call is limited to the premium received plus the difference between the stock’s purchase price and the strike price. The maximum potential loss is the stock’s purchase price minus the premium, which occurs if the stock price falls to zero. While the premium provides some downside protection, it does not fully eliminate the risk of loss if the stock experiences a significant decline.

Executing a Covered Call Trade

To initiate a covered call trade, an investor needs a brokerage account with the appropriate options trading approval level. Most brokerages classify options trading into levels, and covered calls are typically permitted at Level 1, the most basic approval tier. This approval process involves questions about an investor’s financial situation, trading experience, and investment objectives.

The next step involves selecting the underlying stock. An investor must own at least 100 shares of the desired stock for each call option contract they sell. After selecting the stock, the investor chooses the specific call option contract from the options chain. This involves deciding on a suitable strike price and an expiration date that align with their market outlook and income goals.

Placing the order involves navigating to the options trading section of the brokerage platform. The investor selects the “sell to open” order type, specifies the number of contracts (e.g., one contract for 100 shares), and sets a limit price for the premium. After reviewing order details, the investor confirms the trade.

Once the order is placed, monitor the trade’s performance. The value of the option and the underlying stock will fluctuate, influencing the profitability of the position. When an option expires worthless, the premium is generally treated as a short-term capital gain for tax purposes. If the option is exercised, the premium is added to the proceeds from the stock sale. The stock’s holding period determines whether any capital gain or loss is short-term or long-term.