How to Trade Covered Calls: A Step-by-Step Process

Covered calls are an options strategy that allows investors to generate income from shares of stock they already own. This involves selling a call option contract against an existing stock position, granting another party the right to purchase those shares at a predetermined price within a specific timeframe. The strategy provides a way to earn a premium, which is a cash payment, in exchange for potentially selling the stock at a set price. It is often employed by those who hold a neutral to moderately bullish outlook on their stock’s short-term price movement.

Understanding Covered Calls

A covered call strategy combines owning at least 100 shares of a specific stock and simultaneously selling one call option contract for every 100 shares owned. The term “covered” signifies that the investor already possesses the underlying shares. This mitigates the unlimited risk associated with selling call options without owning the stock. This contrasts with “naked” call selling, where the seller does not own the shares and faces substantial risk if the stock price rises significantly.

When a covered call is sold, the investor receives an upfront premium payment from the option buyer. This premium is the primary motivation for employing the strategy, as it provides an immediate income stream from existing stock holdings. In return for this premium, the investor grants the option buyer the right to purchase their 100 shares at a specified strike price on or before a particular expiration date.

This strategy allows investors to profit from the premium if the stock price remains below the strike price at expiration. Alternatively, they can sell their shares at the strike price plus the premium if the option is exercised. The premium received offers a limited buffer against potential losses if the stock price experiences a minor decline. This income generation is attractive when the underlying stock’s price is not expected to move significantly upward.

Preparing for Covered Call Trading

Before trading covered calls, investors must ensure their brokerage account is approved for options trading. This typically involves completing an application that assesses an investor’s financial situation, investment objectives, and trading experience. Brokerage firms use this information to determine the appropriate options trading level, with covered calls generally falling under a more basic approval tier.

Selecting the right underlying asset is an important preparatory step. Stocks chosen for covered calls often exhibit ample liquidity, ensuring options can be traded efficiently without wide price discrepancies. Moderate volatility is also a consideration, as it allows for attractive option premiums without excessive risk of the stock moving sharply above the chosen strike price. Investors often select stocks they are comfortable owning long-term, even if the option is not exercised.

Understanding essential options terminology is important before placing a trade. Key terms include the strike price, which is the predetermined price at which the shares may be sold, and the expiration date, the final date the option can be exercised. The premium is the cash payment received for selling the option.

Placing a Covered Call Order

Executing a covered call trade involves a series of specific actions within a brokerage platform. The process typically begins by navigating to the options trading section for the desired stock. Investors then select the specific security on which they wish to sell the call option.

Within the options chain, the investor chooses the desired expiration date and strike price for the call option. The action selected will be “Sell to Open,” indicating the initiation of a new short options position. This action is distinct from “Buy to Open” or “Sell to Close.”

The investor specifies the quantity of contracts they wish to sell. Each contract represents 100 shares of the underlying stock. For instance, selling one contract corresponds to 100 shares, two contracts to 200 shares, and so on. It is crucial to ensure the number of contracts sold does not exceed the number of shares owned.

The order type is typically set as a “Limit Order” to control the premium received. A limit order ensures the option is sold at a specified price or better, rather than at the prevailing market price, which can fluctuate rapidly. After inputting all details, the investor reviews the order summary to confirm the strike price, expiration date, premium, and number of contracts before confirming the trade. Some brokerage platforms also allow for a “Buy Write” order, which combines buying the stock and selling the call option in a single transaction.

Handling Covered Call Expiration

As the expiration date of a covered call approaches, several scenarios can unfold. If the stock price at expiration is below the selected strike price, the call option will expire worthless. The investor retains both the premium initially received and full ownership of their shares. This allows the investor to consider selling another covered call on the same shares to generate additional income.

If the stock price is above the strike price at expiration, the option will likely be exercised, a process known as assignment. This obligates the investor to sell their shares at the predetermined strike price. The investor keeps the premium received and sells the stock at the strike price, capping the profit on the stock’s appreciation at that level. For tax purposes, the premium received is generally added to the sale proceeds of the stock, influencing the capital gain or loss calculation.

Investors can actively manage their covered call positions before expiration by “buying back” or “buying to close” the option. This involves purchasing an identical call option to offset the one initially sold, thereby closing the position. This action might be taken to realize a profit, avoid assignment if the stock price has risen significantly, or to free up the underlying shares. Any gain or loss from buying back the option is typically treated as a short-term capital gain or loss.

Another management strategy is “rolling the option.” This involves simultaneously buying back the existing covered call and selling a new call option with a later expiration date or a different strike price. Rolling allows investors to extend income generation, adjust their position based on market changes, or potentially avoid assignment while maintaining ownership of their stock. This can be useful if the stock price has moved unfavorably, or if the investor wishes to capture more premium from a new contract.