How to Close a Covered Call Before Expiration

A covered call is an investment strategy involving ownership of at least 100 shares of a stock and the simultaneous sale of a call option contract against those shares. This approach generates income through the premium received from selling the option. Investors often use covered calls to earn additional returns on their stock holdings, particularly when they anticipate the stock’s price will remain stable or experience only a modest increase. While covered calls are frequently held until their expiration date, there are situations where an investor might choose to close the position early. This decision can be influenced by market movements or strategic adjustments to the investment portfolio.

Reasons to Close a Covered Call

Investors may decide to close a covered call position before its expiration to manage profit, limit potential losses, or adjust their market outlook. One common motivation is to secure profits if the option’s premium has significantly decayed or if the stock price has moved favorably, allowing the investor to buy back the option at a lower cost than it was sold for. A covered call can also be closed to mitigate losses if the underlying stock experiences an unexpected decline. Buying back the option can prevent further losses if the stock continues to fall.

Another reason is to avoid the assignment of shares. If the stock’s price rises above the strike price, the option holder may exercise their right to buy the shares, obligating the covered call writer to sell their stock. Closing the call early allows the investor to retain ownership of their stock. Additionally, closing a covered call can free up capital that was tied to the option contract, providing flexibility to pursue other investment opportunities.

Strategies for Closing a Covered Call

Two primary strategies exist for closing a covered call position before its expiration: a direct buy-to-close transaction or rolling the option. Both methods aim to terminate the existing obligation created by selling the call option. The choice between these strategies depends on the investor’s objectives and market expectations.

The simplest method is a “buy-to-close” order, which involves purchasing the exact same call option that was originally sold. This action effectively cancels out the original short call position. If the option is bought back for less than the initial premium received, the investor realizes a profit. Conversely, if the buy-back cost exceeds the initial premium, the transaction results in a loss. This strategy is often used to lock in gains when the option has lost most of its value due to time decay or favorable stock movement, or to cut losses if the stock moves adversely.

Alternatively, investors can “roll” the option, a more dynamic two-part transaction. Rolling involves simultaneously buying back the existing call option and selling a new call option on the same underlying stock. The new option usually has a different strike price, expiration date, or both, adjusting the position to current market conditions or future expectations. This combined transaction allows investors to maintain a covered call position while modifying its terms.

Different types of rolling strategies serve various purposes:

Rolling Up

This involves selling a new option with a higher strike price, used when the stock price has risen significantly to capture more upside while generating premium.

Rolling Down

This means selling a new option with a lower strike price, a defensive move used when the stock price has declined. This can bring in additional premium to offset losses or reduce the breakeven point.

Rolling Out

This extends the expiration date of the option, keeping the same strike price but moving to a later month. This strategy is useful to continue generating income or give the stock more time to recover without immediate assignment risk.

Rolling Up and Out

This common strategy combines a higher strike price with a later expiration date, allowing for increased potential income and additional time for the stock to appreciate.

Rolling a covered call effectively adjusts the investment’s risk and reward profile in response to market changes, providing flexibility beyond simply closing the position outright.

Executing the Covered Call Close

Executing a covered call close involves steps on a brokerage platform to terminate the existing option obligation. The process begins by navigating to the “Positions” or “Portfolio” section of your online brokerage account, where all your current investments, including open option contracts, are listed.

Once on the positions page, locate the specific covered call option you intend to close. After selecting the option, you will find an option to “Close,” “Buy to Close,” or a similar function, which initiates the closing order process.

On the order ticket, select an order type. A “limit order” allows you to specify the maximum price you are willing to pay to buy back the option. This provides control over the execution price, though it may delay fulfillment if the market price does not meet your limit. Alternatively, a “market order” instructs the broker to execute the trade immediately at the best available price. While a market order ensures prompt execution, it carries the risk of price slippage, where the actual execution price might differ from the quoted price, especially in fast-moving markets.

Enter the number of contracts you wish to close. Covered calls are typically sold in contracts representing 100 shares of stock; enter the number of contracts accordingly. Before submitting, a review screen will display the estimated cost, including commissions or fees. After reviewing all details, confirm the order to transmit it to the market.

For rolling a covered call, many brokerage platforms offer a dedicated “Roll” function that streamlines the two-part transaction into a single order entry. This feature allows simultaneous buying back of the old option and selling a new one, often with adjusted strike prices or expiration dates. If a dedicated roll function is not available, place two separate, sequential orders: a buy-to-close for the existing option followed by a sell-to-open for the new option. After submission, monitor the order status in your account’s history to confirm execution.

Reporting Covered Call Transactions

The financial outcome of closing a covered call position has tax implications for accurate reporting. Any profit or loss realized from closing a covered call is treated as a capital gain or capital loss, whether the option expires worthless, is bought back, or if the underlying shares are assigned.

The classification of these gains or losses as short-term or long-term depends on the option contract’s holding period, not the underlying stock. For most covered call transactions, the resulting gain or loss is considered short-term because options are typically held for less than one year. Short-term capital gains are subject to taxation at an investor’s ordinary income tax rates, which can range from 10% to 37% depending on their taxable income. In contrast, long-term capital gains, derived from assets held for more than one year, typically receive more favorable tax treatment with lower rates.

Brokers report option transactions to the Internal Revenue Service (IRS) on Form 1099-B, “Proceeds From Broker and Barter Exchange Transactions.” This form details proceeds from sales of securities, including options, and helps investors calculate capital gains or losses. Form 1099-B includes information such as the description of the property, the date of acquisition and sale, and the sales proceeds. While the form provides a summary, investors are responsible for accurately reporting these transactions on their tax returns, typically on Schedule D, “Capital Gains and Losses,” and Form 8949, “Sales and Other Dispositions of Capital Assets.” If shares are assigned, the premium received from the covered call adjusts the effective sale price of the stock, influencing the capital gain or loss on the stock sale.