How to Write a Covered Call Option

A covered call is an options strategy for investors who own shares of a particular stock. It involves selling call options against these existing shares, which effectively “covers” the option’s obligation. This allows stock owners to generate income by collecting a premium, enhancing portfolio returns.

Essential Concepts for Covered Calls

Understanding covered calls requires grasping several foundational concepts. The primary requirement is owning at least 100 shares of a specific company’s stock, referred to as the “underlying stock.” This ownership is fundamental because each standard equity option contract represents 100 shares, ensuring the seller has assets to fulfill their potential obligation.

A call option grants its buyer the right, though not the obligation, to purchase 100 shares of the underlying stock from the seller at a predetermined price. In a covered call, the investor holding the shares acts as the seller. The term “covered” means the investor already owns the equivalent number of shares to fulfill the potential delivery obligation if the option buyer exercises their right. This contrasts with “naked” options, where the seller does not own the underlying asset.

Several key terms define an options contract. The strike price is the specific price per share at which the underlying stock can be bought or sold if the option buyer chooses to exercise their right. This fixed price is established when the option contract is initiated. The expiration date is when the option contract becomes void and the right to exercise it ceases, typically on the third Friday of the month for standard options.

The premium is the upfront payment received by the option seller from the option buyer for entering the contract. This payment is credited to the seller’s brokerage account upon trade execution. The amount of this premium is influenced by market factors, including the relationship between the strike price and current stock price, time until expiration, and underlying stock volatility.

Preparing Your Brokerage Account

Before initiating a covered call trade, your brokerage account must be set up and approved for options trading. A standard investment account is insufficient; a dedicated brokerage account with specific options privileges is required. Most firms categorize options trading into various approval levels, with covered calls typically falling under a lower, more accessible tier.

Gaining options trading approval usually involves completing an application within the brokerage platform. This application includes questions about an investor’s financial experience, investment objectives, and understanding of options risks. The brokerage firm requires acknowledgment that the investor comprehends the general nature of options contracts. The approval process can take a few hours to several business days, depending on the brokerage and application completeness.

Once approval is granted, ensuring the account is adequately funded is the next step. This means holding the shares of the underlying stock in the account, or having cash to purchase the necessary 100 shares per contract. Without the required shares or capital, a covered call cannot be written.

Executing a Covered Call Trade

With the brokerage account prepared and funded, navigate the trading platform to execute the covered call. Investors typically access the options trading section, often found within the main trading or investing tab. From there, select the specific underlying stock you own and wish to use for writing the covered call.

Once the stock is selected, the platform displays an options chain listing available call and put options. The investor then chooses an appropriate expiration date and a strike price from this chain. These selections directly influence the premium received and the potential for shares to be called away. Options with shorter expirations or strike prices closer to the current stock price generally yield higher premiums.

After selecting the desired expiration date and strike price, specify the order type. For a covered call, the appropriate order type is “Sell to Open” or “Write Call,” indicating a new short option position. Next, the quantity of contracts needs to be entered; one option contract typically corresponds to 100 shares. For instance, if an investor owns 300 shares, they can sell up to three option contracts.

Finally, the investor sets the premium they wish to receive for selling the option. It is generally recommended to use a limit order, which allows the investor to specify the minimum premium they are willing to accept. This contrasts with a market order, which fills immediately but offers less control over the premium received. Before submitting, review all order details: stock symbol, expiration date, strike price, premium, quantity, and any associated commission fees (typically $0.50-$1.00 per contract). After confirming the details, the order can be placed.

Post-Trade Management and Outcomes

After a covered call trade is placed, continuous monitoring of the position becomes important. This involves tracking the underlying stock’s price in relation to the option’s strike price, and observing the time remaining until the expiration date. Market movements can significantly impact the likelihood of the option being exercised or expiring worthless.

Investors have the flexibility to close the covered call position early by executing a “buy to close” order before the expiration date. This involves buying back the same option contract that was initially sold. Closing early might be considered if the stock price moves unfavorably, to lock in a profit, or to remove the obligation to potentially sell shares. The cost to buy back the option depends on its current market value.

At expiration, two primary scenarios exist for a covered call. If the underlying stock’s price remains below the strike price, the call option will expire worthless. In this outcome, the option buyer will not exercise their right, and the seller retains both the initial premium and ownership of the underlying stock. This allows the investor to potentially write another covered call on the same shares.

Conversely, if the stock price is above the strike price at expiration, the option is “in the money” and likely assigned. Assignment means the option buyer exercises their right, obligating the seller to sell their 100 shares per contract at the strike price. The investor keeps the premium initially received, which helps offset any potential capital gains tax. As an alternative to assignment, an investor might “roll” the covered call, closing the current option and simultaneously opening a new covered call position with a different strike price, a later expiration date, or both.