How to Close a Covered Call Position Early

A covered call is an options strategy where an investor owns shares of a stock and simultaneously sells call options against those shares. This generates income through the premium received. The strategy allows investors to earn additional returns on their stock holdings, particularly when the stock price is not expected to move significantly upward. A covered call can be actively managed and closed before its scheduled expiration date, providing flexibility to adjust based on market changes or personal objectives.

Reasons for Closing a Covered Call Early

Investors often close a covered call position early for several strategic reasons.
Secure Profits: One motivation is to secure profits if the option’s premium has significantly declined. This reduction can occur due to time decay or a drop in implied volatility, allowing the investor to buy back the option for less than the original sale price. This locks in the profit from the option component of the strategy.
Avoid Assignment: Another reason is to avoid assignment, particularly if the underlying stock price has risen substantially above the option’s strike price. When assignment becomes likely, the investor would be obligated to sell their shares at the strike price, capping potential gains. Closing the call prevents the automatic sale of shares, allowing the investor to retain their stock and benefit from further appreciation.
Roll the Position: Investors may also close a covered call early to “roll” the position. This involves closing the existing call and opening a new one with different terms, such as a higher strike price or a later expiration date. Rolling can generate additional premium income or adjust the strategy to align with a new market outlook for the underlying stock.
Free Up Shares: The need to free up shares is another practical reason. If an investor decides to sell their underlying stock, any open covered call position must first be closed. This ensures the shares are unencumbered and available for sale.
Change in Market Outlook: A significant change in the investor’s market outlook, perhaps due to company news or broader economic shifts, can prompt an early exit to realign the portfolio.

Methods for Closing a Covered Call Early

Closing a covered call position early primarily involves executing a “buy to close” order. This action cancels the obligation of the call option that was originally sold. The investor purchases an identical option contract to the one previously sold, neutralizing the position and removing the obligation to sell shares.

To close, log into a brokerage account and navigate to the options trading platform. Select the specific call option. The order type will be “buy to close,” and the quantity of contracts must match the number originally sold. Investors can use various order types, such as a limit order, to control the buy-back price.

Once order details are confirmed, submit the request. The goal of this “buy to close” action is to extinguish the short call obligation, often at a lower price than the initial sale, realizing a profit on the option leg of the trade.

Another common method is rolling the position, a combination of two transactions. This involves simultaneously buying back the existing call option (a “buy to close” order) and selling a new call option (a “sell to open” order). Many brokerage platforms offer a specialized “roll” function that automates these combined orders. This makes it efficient to adjust the covered call’s strike price, expiration date, or both, without executing two separate trades. Rolling can be performed in various ways, such as “rolling up” to a higher strike price, “rolling out” to a later expiration date, or a combination.

Factors Affecting the Cost of Closing Early

The cost to buy back a covered call option is influenced by several market dynamics.
Underlying Stock Price: If the stock price decreases after the call option is sold, the option’s value generally declines, making it cheaper to buy back. Conversely, if the stock price rises, the option becomes more valuable, increasing the cost to close.
Time Decay (Theta): As an option approaches its expiration date, its extrinsic value erodes, meaning its price decreases over time. This decay generally works in favor of the option seller, making it less expensive to buy back a covered call as expiration nears. The rate of time decay accelerates significantly during the last few weeks or days before expiration.
Implied Volatility (Vega): Implied volatility reflects the market’s expectation of future price swings in the underlying stock. A rise in implied volatility typically increases the option’s premium, making it more expensive to buy back. Conversely, a decrease in implied volatility generally lowers the option’s premium, reducing the cost to close.
Dividends: Dividends can affect option pricing. When a company pays a dividend, the stock price typically drops by the dividend amount on the ex-dividend date. This can reduce the value of call options, potentially making them slightly cheaper to buy back just before the ex-dividend date. However, for in-the-money options, there is a risk of early assignment before the ex-dividend date as the option buyer may exercise to capture the dividend, which could require the seller to buy back the option at a higher cost or deliver shares.

Tax Implications of Closing Early

Closing a covered call early has specific tax implications. Any profit realized from buying back the call option for less than the original premium received is generally considered a capital gain. If the option was held for one year or less, this gain is typically classified as a short-term capital gain, taxed at the investor’s ordinary income tax rate.

Conversely, if the cost to buy back the call option exceeds the premium originally received, the difference results in a capital loss. This loss is also generally treated as short-term, regardless of the option’s duration. These capital gains and losses from options transactions are typically reported on IRS Form 8949 and then summarized on Schedule D of Form 1040 when filing annual tax returns.

The tax treatment of the option portion of a covered call is separate from the underlying stock, unless the stock is assigned. If the option expires worthless, the entire premium received is typically reported as a short-term capital gain. Investors should consult with a qualified tax professional for personalized advice regarding their specific tax situation, as tax laws can be complex and individual circumstances vary.