What Are Covered Call Options and How Do They Work?

Options are financial contracts that derive their value from an underlying asset, such as a stock, bond, or commodity. These instruments provide the holder with the right, but not the obligation, to buy or sell the underlying asset at a predetermined price within a specific timeframe. This article details covered call options, a common strategy for investors seeking to generate income from their stock holdings.

Understanding Covered Call Fundamentals

A covered call option involves an investor holding a long position in a stock while simultaneously selling call options on that same asset. The term “covered” signifies that the investor owns the underlying shares, providing the necessary backing for the obligation assumed by selling the call option. This strategy allows the investor to generate income from the premium received for selling the option.

A covered call strategy requires the investor to own at least 100 shares of the stock for each call option contract sold. One options contract typically represents 100 shares of the underlying asset. Owning these shares ensures that the seller can fulfill their obligation if the option is exercised.

A call option contract grants the buyer the right, but not the obligation, to purchase the underlying stock at a specified price. Conversely, the seller of the call option takes on the obligation to sell those shares if the buyer chooses to exercise their right.

The strike price is the predetermined price at which the underlying stock can be bought if the option is exercised. The expiration date defines the last day the option contract remains valid, after which it becomes worthless if not exercised.

The premium is the upfront cash amount the option seller receives for selling the contract. This payment reduces the cost basis of their existing stock position. The premium is the primary income generated through a covered call strategy.

Options are categorized based on their relationship between the strike price and the current market price of the underlying stock. An option is considered “in-the-money” (ITM) if the stock price is above the strike price for a call option. An option is “at-the-money” (ATM) when the strike price is equal or very close to the current stock price. Conversely, an option is “out-of-the-money” (OTM) if the stock price is below the strike price.

Mechanics of Covered Call Options

Selling a covered call involves an investor, already holding 100 shares of a particular stock, sells a call option contract against those shares. This action creates an obligation for the seller to deliver their shares at the specified strike price if the option buyer chooses to exercise the contract. The shares held by the investor act as collateral, ensuring the seller can meet this potential obligation.

Upon selling the call option, the investor receives the premium, which is the payment from the option buyer. This premium is retained by the seller regardless of the option’s outcome, providing an income stream. The premium received contributes to the overall return of the strategy and offers a limited buffer against potential declines in the stock’s price.

If the stock price remains below the strike price at the option’s expiration date, the call option will expire worthless because it is out-of-the-money for the buyer. The seller then keeps the entire premium received and retains ownership of their underlying shares. This outcome allows the investor to potentially sell another covered call for a future expiration date, continuing to generate income from the same stock.

If the stock price rises above the strike price at expiration, the option is in-the-money, and the buyer will likely exercise their right to purchase the shares. This action, known as “assignment,” obligates the covered call seller to sell their 100 shares at the predetermined strike price, even if the market price has climbed significantly higher. The sale price for tax purposes in this scenario is generally considered the strike price plus the net premium received.

If the stock price is at or very near the strike price at expiration, the outcome can depend on factors like the remaining time value and specific brokerage practices. However, if the option is even slightly in-the-money, it is typically exercised. The primary consideration for the option buyer is whether exercising the option offers a financial advantage compared to buying the shares directly in the market. The investor should always be prepared for the possibility of their shares being called away when the option is in the money.

Implementing a Covered Call Strategy

A covered call strategy is to generate additional income from existing stock holdings. The premium received from selling the call option provides a recurring revenue stream, which can enhance the overall yield on a portfolio. This approach can be particularly appealing when an investor expects the underlying stock’s price to remain relatively stable or experience only a modest increase.

Another goal of this strategy is to potentially reduce the cost basis of the shares held. The premium collected lowers the average price paid for the stock, offering limited downside protection. If the stock price declines, the premium received can offset a portion of those losses.

A direct consequence of selling a covered call is the limitation of potential profit on the underlying stock. By agreeing to sell shares at the strike price, the investor caps their upside gain at that price, plus the premium received. While the strategy generates income, it sacrifices participation in substantial stock appreciation beyond the strike price. The maximum profit potential is the difference between the strike price and the stock’s purchase price, combined with the premium collected.

To initiate a covered call trade, an investor’s brokerage account needs the necessary options trading approval level. After gaining approval, the investor navigates their brokerage platform to the specific underlying stock they own or wish to purchase.

The next step involves selecting the specific call option contract to sell, which entails choosing a strike price and an expiration date. Investors often consider strikes that are out-of-the-money to allow for some stock appreciation while still collecting a premium. The expiration date selected impacts the premium amount, with longer-dated options generally commanding higher premiums.

Once the desired option is identified, the investor enters an order to “sell to open” the position. They will specify the quantity of contracts, typically one contract for every 100 shares owned, and the investor confirms the trade.

The concept of “being assigned” occurs when the option buyer exercises their right to purchase the shares. The tax implications of covered calls depend on the outcome; if the option expires worthless, the premium is generally considered a short-term capital gain. If the option is assigned, the premium is added to the sale price of the stock.