How to Write Covered Calls to Generate Income

Understanding Covered Calls

A covered call is an options trading strategy where an investor owns shares of a particular stock and simultaneously sells a call option on those same shares. This strategy aims to generate additional income from the premium received. It is considered “covered” because the investor already owns the underlying stock, which acts as collateral for the potential obligation to sell. This approach is often favored when the stock’s price is expected to remain relatively stable or experience a moderate increase.

A call option is a contract that gives the buyer the right, but not the obligation, to purchase an underlying asset at a specified price (the strike price) on or before a certain date (the expiration date). When an investor sells a call option, they are the “writer” and receive a payment, called the premium, from the buyer. This premium is the core income generated. Each option contract typically represents 100 shares of the underlying stock.

The underlying stock refers to the shares the investor owns. The strike price is the predetermined price at which the shares would be sold if the option is exercised. The expiration date sets the deadline for exercise. The premium is the upfront cash payment the option seller receives, which they keep regardless of whether the option is exercised. These elements create a strategy that can provide recurring income while potentially limiting upside gains.

Prerequisites for Writing Covered Calls

An investor must have an approved brokerage account that permits options trading. Brokerage firms have different approval levels, with covered calls generally falling under a more basic authorization due to their lower risk profile compared to other options strategies.

To obtain options trading approval, investors usually need to provide information about their financial experience, investment objectives, and risk tolerance. This assessment helps the brokerage determine the appropriate level of options trading activity. Covered calls are often a suitable starting point for those new to options.

A primary requirement for a covered call is the ownership of at least 100 shares of the specific stock on which the call option will be written. This ensures the investor can fulfill their obligation to deliver the shares if the option is exercised. Without owning the shares, selling a call option would be considered “naked” and carry significantly higher risk. Considering the liquidity of the underlying stock can also be beneficial.

Key Decisions Before Writing a Covered Call

The selection of the underlying stock is a primary consideration; investors often choose shares they already own and are comfortable holding long-term. Factors such as the stock’s historical volatility, dividend policy, and outlook on its future price movement are relevant. A stock with moderate volatility might be preferred, as high volatility can complicate the strategy.

The choice of the strike price is important, as it defines the price at which the shares could be sold if the option is exercised. Investors can select a strike price that is in-the-money (current stock price above strike), at-the-money (strike price equal to current stock price), or out-of-the-money (current stock price below strike). Out-of-the-money strikes offer a lower premium but a higher probability of keeping the stock. Conversely, in-the-money or at-the-money strikes yield a higher premium but increase the likelihood of shares being called away. The decision often aligns with the investor’s objective: prioritizing premium income or retaining stock ownership.

Determining the expiration date dictates the timeframe during which the option contract is valid. Options with longer expiration periods generally command higher premiums due to more time for the stock’s price to move. However, longer expirations also tie up the underlying shares for a greater duration. The concept of time decay, or “theta,” means options lose value as they approach expiration, with this decay accelerating in the final weeks. For covered call writers, this time decay works in their favor, potentially allowing the option to expire worthless. Investors often balance the desire for higher premiums with the desire for shorter commitments, frequently choosing expirations from a few weeks to a few months.

Executing a Covered Call Trade

An investor logs into their approved brokerage account and navigates to the options trading section. This section is typically distinct from regular stock trading interfaces.

Within the options platform, the investor selects the specific stock. The next action is to choose “sell to open” for a call option, indicating a new short option position. This is distinct from “buy to open” or “sell to close” orders. The chosen strike price and expiration date are then entered into the order form.

The investor must specify the number of contracts they wish to sell. A limit order is common for options to ensure the desired premium is received. A limit order allows the investor to set the minimum price they are willing to accept. Before final submission, the order details are reviewed for accuracy.

Managing Covered Call Outcomes

One common outcome is that the option expires worthless if the stock’s price remains below the strike price at expiration. In this situation, the option buyer will not exercise their right, and the covered call writer retains both the premium collected and their original shares. This allows the investor to potentially write another covered call on the same shares, continuing to generate income.

Conversely, if the stock price rises above the strike price by the expiration date, the option will likely be exercised, a process known as assignment. The covered call writer is obligated to sell their shares at the predetermined strike price, even if the market price is higher. While the investor misses out on further appreciation above the strike price, they still keep the premium received, which contributes to their overall profit. This scenario means the shares are “called away.”

To manage positions, investors can consider “rolling” the option. Rolling involves buying back the current call option to close the position and simultaneously selling a new call option with a different strike price, expiration date, or both. For instance, an investor might roll “up and out” by buying back an existing call and selling a new one with a higher strike price and a later expiration date, aiming to collect more premium or give the stock more time to move.

From a tax perspective, premiums received from covered calls are generally treated as income. If the option expires worthless, the entire premium is typically considered short-term capital gain income. If the option is assigned and the shares are called away, the transaction results in a sale of the stock. This sale triggers a capital gain or loss, calculated based on the difference between the stock’s cost basis and the strike price plus the premium received. Investors should maintain accurate records for tax reporting purposes.