How to Close a Covered Call Before Expiration

A covered call involves selling a call option contract against 100 shares of a stock an investor already owns, generating income through the premium received. Effectively managing this position often requires understanding how to close it before expiration. Proactively closing a covered call can help lock in profits, mitigate potential losses, or regain control of the underlying shares.

Understanding Closing Methods

A covered call position can conclude in several ways, each with distinct outcomes for the investor. The most active and common method to close a covered call is to “buy to close” the option. This action involves purchasing the identical call option that was originally sold, effectively canceling out the obligation and freeing the underlying shares. Investors often choose this method to secure a profit on the option, reduce a potential loss, or prevent their shares from being called away if the stock price rises significantly.

Another scenario involves letting the option expire worthless, which is a passive closing method. If the stock’s market price remains below the option’s strike price at expiration, the option typically expires unexercised. In this situation, the investor retains the full premium received from selling the option, and no further action is required. The underlying shares remain in the investor’s portfolio, ready for a new covered call to be written.

The third method of resolving a covered call is through assignment, which occurs if the option’s strike price is below the market price of the stock at expiration. When assigned, the investor is obligated to sell their 100 shares of the underlying stock at the option’s strike price. This results in the stock being “called away,” and the investor keeps the initial premium received from selling the option. Assignment is a forced closing mechanism, meaning the investor loses ownership of the shares, but at a predetermined price.

Executing a Buy-to-Close Order

Actively closing a covered call position by buying back the option begins with accessing your online brokerage account. After logging in, navigate to your portfolio or options positions section, where your active covered call contracts will be listed. Locate the specific covered call you wish to close, identifiable by its ticker symbol, strike price, and expiration date.

Once the specific option contract is identified, you will find an option to “Buy to Close” or a similar phrase. Clicking this initiates the trade order entry process. Confirm the quantity of contracts you wish to close, matching the number you initially sold. For the order type, a “limit order” is recommended for options, allowing you to specify the maximum price you are willing to pay to buy back the option.

While a “market order” can execute immediately, it does not guarantee a specific price and can be subject to price fluctuations, especially for less liquid options. A limit order allows you to input the desired price, controlling the cost of closing the position. You will also select the “Time in Force,” such as “Day” (active for the current trading day) or “Good ’til Canceled” (GTC), which remains active until filled or canceled.

Before submitting the order, a review screen will display all the details of your buy-to-close request. Verify the option contract details, quantity, price, and order type for accuracy. After confirming, submit the order and monitor its status within your brokerage account to confirm successful execution. This action removes the covered call obligation and frees your underlying shares.

Financial and Tax Implications

The financial outcome of a covered call strategy depends on how the position is closed. If an option expires worthless, the entire premium received becomes profit. If the option is bought back, profit or loss is calculated by subtracting the cost of buying to close from the initial premium. For example, receiving $1.50 per share ($150 per contract) and buying it back for $0.50 per share ($50 per contract) yields a $1.00 per share ($100 per contract) profit.

If the covered call is assigned, the profit on the option is the premium received. However, the overall investment gain or loss also includes the difference between the stock’s purchase price and the strike price at which it was sold. For instance, buying stock at $40 and selling a call with a $45 strike that is assigned means you profit from the $5 per share stock appreciation plus the premium. The total profit or loss considers both the option premium and the underlying stock’s gain or loss.

From a tax perspective, gains and losses from options transactions, including covered calls, are treated as capital gains or losses. Most covered call options are held for less than one year, so any gains or losses realized from the option are considered short-term capital gains or losses. These short-term gains are taxed at an individual’s ordinary income tax rate. Long-term capital gains, which apply if an asset is held for more than one year, have lower tax rates, but this is rare for the option component of a covered call.

All option transactions, including the sale of the call and its subsequent closing (by expiration, buy-to-close, or assignment), must be reported to the Internal Revenue Service (IRS). These transactions are reported on IRS Form 8949, Sales and Other Dispositions of Capital Assets, and summarized on Schedule D, Capital Gains and Losses. A specific tax consideration is the wash sale rule, which applies if the underlying stock is sold at a loss (e.g., through assignment) and then substantially identical stock is reacquired within 30 days before or after the sale. In such cases, the loss on the stock sale may be disallowed for tax purposes, requiring careful consideration of reinvestment timing.