How to Sell a Covered Call: A Step-by-Step Process

Understanding Covered Calls

A covered call is an options trading strategy where an investor holds an underlying stock and simultaneously sells call options against those shares. This approach aims to generate additional income through the premium received from selling the option. The term “covered” means the investor already owns the shares, which protects against the obligation to deliver the stock if the option is exercised. This strategy is often used by investors who anticipate the stock price will remain relatively stable or experience only a modest increase.

The core components of a covered call include the underlying stock, the call option, a strike price, an expiration date, and the premium. The underlying stock refers to the shares the investor already owns, typically in increments of 100 shares for each option contract. The call option grants the buyer the right, but not the obligation, to purchase these shares from the seller at a predetermined price (the strike price) before or on a specific expiration date. In exchange for this right, the seller receives an upfront payment called the premium.

For example, if an investor owns 100 shares and sells one call option, they receive the premium immediately. If the stock price stays below the strike price until expiration, the option expires worthless, and the seller keeps the premium and their shares. If the stock price rises above the strike price, the option buyer may exercise their right, obligating the seller to sell their 100 shares at the agreed-upon strike price. This allows the investor to profit from the premium while potentially capping upside profit if the stock price increases significantly.

Prerequisites for Selling Covered Calls

Before an investor can engage in selling covered calls, several foundational requirements must be satisfied. A primary requirement involves stock ownership, specifically possessing at least 100 shares of the underlying stock for each call option contract intended for sale.

Investors must also have a brokerage account approved for options trading. Brokerages categorize options trading capabilities into various approval levels. Covered calls generally fall under the most basic level, often Level 1 or Level 2, depending on the firm. These levels are granted based on an investor’s trading experience, financial status, and investment objectives.

Understanding key options terminology is also important before initiating a trade. The strike price represents the predetermined price at which the underlying stock can be sold if the option is exercised. The expiration date is the specific date by which the option can be exercised, after which it becomes void. The premium is the income received by the seller for writing the option, which is deposited into their account upon the trade’s execution.

Placing a Covered Call Order

The process of selling a covered call involves navigating a brokerage platform to execute the trade. The first step involves locating the options trading interface within the chosen brokerage account. Investors then select the specific underlying stock they wish to write a covered call against.

To initiate the sale of a new option contract, the investor selects the “sell to open” action. This order type signifies that the investor is creating a new short option position, rather than closing an existing one. Next, the investor chooses a strike price and an expiration date from the available options chain. The options chain displays various call options for the chosen stock, organized by strike price and expiration, allowing the investor to select terms that align with their market outlook and income goals.

It is recommended to use a limit order when selling covered calls. A limit order allows the investor to specify the minimum premium they are willing to receive for the option, ensuring a desired price. This contrasts with a market order, which executes immediately at the best available price but offers no control over the premium received. After inputting the desired strike price, expiration date, and limit price, the investor reviews the order details and submits it for execution.

Managing a Covered Call Trade

If the stock price remains below the strike price at expiration, the option is considered out-of-the-money (OTM). In this common outcome, the option typically expires worthless, allowing the investor to retain both the premium collected and their shares. This allows the investor to potentially sell another covered call on the same shares.

Conversely, if the stock price rises above the strike price by expiration, the option is in-the-money (ITM) and will likely be exercised, leading to assignment. Assignment means the investor is obligated to sell their 100 shares at the predetermined strike price, regardless of the higher market price. While this caps the profit on the stock at the strike price plus the premium, the investor still realizes a gain. For options that are exactly at-the-money (ATM) at expiration, meaning the stock price is equal to the strike price, the likelihood of assignment can vary, though they often expire worthless.

Investors have several options for managing a covered call before expiration. One strategy is to buy back the option, which involves purchasing the same call option to close the position. This action removes the obligation to sell the shares and can be done to avoid assignment if the stock price rises significantly, or to simply close the position and realize any remaining premium profit if the option’s value has decreased. Another management technique is “rolling” the option, which involves simultaneously buying back the current option and selling a new one with a different strike price, expiration date, or both. This allows investors to extend the trade, adjust to changing market conditions, or potentially collect additional premium.