What Happens When a Covered Call Expires In the Money?

A covered call strategy involves owning shares of a stock and simultaneously selling a call option against them. This approach allows investors to generate income from the premium received. An option is “in the money” when the underlying stock’s price rises above the call option’s strike price. For a covered call, this means the stock has appreciated beyond the price at which the option holder can buy the shares. This scenario is a common outcome for covered call writers as expiration approaches.

Understanding Automatic Exercise and Assignment

When a covered call option expires with the underlying stock trading above the strike price, it becomes eligible for automatic exercise. The Options Clearing Corporation (OCC) ensures the orderly settlement of options contracts. The OCC automatically exercises any equity option that is in the money by at least $0.01 at expiration. This automated procedure, known as “Exercise by Exception,” simplifies the process for option holders, as they do not need to manually instruct their broker to exercise.

The assignment process follows automatic exercise, allocating the obligation to deliver shares among call option writers. When an option holder exercises their right to buy shares, the OCC randomly assigns this obligation to a clearing member firm with open short call positions. This random selection means a specific option writer cannot predict if their short call will be assigned. Once a clearing member firm receives an assignment notice, they allocate that assignment to one of their customers who wrote the call option.

Brokerage firms use either a random selection method or a first-in, first-out (FIFO) method for assigning options to their customers. The assignment notice informs the option writer they are obligated to sell their shares at the option’s strike price. This obligation is a direct consequence of selling the call option, granting the buyer the right to purchase the shares. Assignment usually occurs shortly after the option’s expiration, often on the Saturday following the third Friday of the expiration month.

The investor, as the call option writer, does not initiate this process; it is a mechanical outcome of the option expiring in the money. Their broker will notify them of the assignment, typically via a message in their account or a direct email. This notification confirms that the shares held to cover the call option will be delivered to the option buyer.

Financial Outcomes of Assignment

A covered call assignment means the investor’s underlying shares are sold at the option’s strike price. This sale occurs regardless of the stock’s market price at assignment, which is usually higher than the strike price. The investor receives cash proceeds equivalent to the strike price multiplied by the number of shares assigned (100 shares for a standard contract). This transaction fulfills the obligation created when the covered call was initially sold.

To calculate the overall profit or loss from the covered call strategy, an investor must consider several components. The initial premium received from selling the call option is a direct credit to the investor’s account, reducing the net cost of the stock or increasing potential gain. The profit or loss on the stock portion is determined by the difference between the original purchase price of the shares and the strike price at which they were sold due to assignment. For instance, if shares were bought at $50 and sold at a strike price of $55, there is a $5 per share gain from stock appreciation.

The total profit combines the premium received and the gain or loss from the stock sale. For example, if an investor bought shares at $50, sold a call with a $55 strike price for a $2 premium, and the option was assigned, the total profit per share would be $2 (premium) + ($55 – $50) (stock gain) = $7 per share.

From a tax perspective, profit or loss from a covered call assignment is generally treated as a capital gain or loss. The underlying stock’s holding period determines whether the gain or loss is short-term or long-term. If shares were held for one year or less, any gain or loss is short-term and taxed at ordinary income tax rates. If shares were held for more than one year, the gain or loss is long-term and subject to more favorable long-term capital gains tax rates.

The premium received from selling the call option is also considered part of the capital gain or loss. If the option expires unexercised, the premium is generally treated as a short-term capital gain. However, when the option is assigned, the premium reduces the cost basis of the shares for tax purposes, impacting the calculation of the capital gain or loss on the stock sale. Investors receive a Form 1099-B from their brokerage firm, which reports the proceeds from the sale of shares and the cost basis.

Post-Assignment Account Status

Following a covered call assignment, an investor will observe specific changes within their brokerage account. The shares previously held as the underlying asset for the covered call will be removed. This removal fulfills the obligation to deliver those shares to the option buyer. The transaction will be reflected in the account’s activity statement, showing a sale of the shares at the option’s strike price.

Concurrently with the removal of shares, cash proceeds from their sale will be credited to the investor’s account. This cash amount equals the strike price multiplied by the number of shares assigned, less any applicable commissions or fees. Stock transaction settlement typically occurs on a T+2 basis, meaning cash proceeds become available two business days after the assignment date.

For a true covered call, where the investor fully owned the shares before selling the call option, the assignment process is straightforward and does not lead to unexpected liabilities or margin calls. Since the shares were already owned, there is no need to purchase them in the open market to fulfill the obligation, which eliminates the risk of a short position or a margin deficit. The pre-existing ownership of the underlying stock defines the “covered” aspect of the strategy, mitigating potential risks associated with naked options.

Reviewing the transaction history in their brokerage account is advisable. This review allows the investor to confirm the accurate execution of the sale, verify credited cash proceeds, and ensure all associated fees are correctly applied. The account’s position will reflect the cash equivalent of the sold shares, ready for future investment decisions.