What Is a Covered Call and How Does It Work?

Options trading involves contracts that give buyers rights, not obligations, to buy or sell an underlying asset at a set price within a specific timeframe. A covered call is a fundamental strategy in this landscape, blending stock ownership with options to generate income. This approach represents a way to potentially enhance returns from existing stock holdings. It is often considered by investors looking to add a layer of income generation to their portfolio, particularly in market conditions where significant price movements are not anticipated.

Defining a Covered Call

A covered call is an options strategy built upon two primary components: owning at least 100 shares of a specific stock and simultaneously selling a call option against those shares. The term “covered” indicates that the investor already possesses the underlying stock, which acts as collateral to fulfill the obligation if the option buyer decides to exercise their right. This ownership helps mitigate the risk associated with selling an uncovered or “naked” call, where the seller does not own the underlying shares.

The “underlying asset” refers to the stock shares the investor holds, typically in increments of 100 shares per option contract. A “call option” is a financial contract that grants the buyer the right, but not the obligation, to purchase the underlying stock from the seller at a predetermined price. This predetermined price is known as the “strike price,” and it is the price at which the shares would be sold if the option is exercised. Every option contract has an “expiration date,” after which it ceases to be valid. When an investor sells a call option, they receive an upfront payment called the “premium,” which is kept by the seller regardless of whether the option is exercised or expires worthless.

The Mechanics of a Covered Call

Implementing a covered call involves a specific process, beginning with the selection of the underlying stock. An investor typically chooses a stock they already own, or intends to purchase, in lots of at least 100 shares. This stock forms the foundation of the covered call. With the stock in place, the next step involves selecting a call option to sell.

This involves choosing a specific strike price and an expiration date. The strike price is usually set above the current market price of the stock, meaning the option is “out-of-the-money” at the time of sale. Once these parameters are chosen, the investor sells, or “writes,” the call option through their brokerage account. Upon selling the call option, the investor immediately receives the premium, which is credited to their account.

The act of selling the call option creates an obligation for the seller: if the stock’s price rises above the strike price before or by the expiration date, the seller may be required to sell their 100 shares at the agreed-upon strike price to the option buyer. This obligation is central to the covered call strategy, as it caps the potential upside profit from the stock’s price appreciation beyond the strike price. The primary aim of this strategy is to generate income from existing stock holdings. This income can help offset the stock’s cost basis or provide a consistent return in flat or moderately rising markets.

Scenarios at Expiration

The outcome of a covered call position at its expiration date largely depends on where the underlying stock’s price stands relative to the option’s strike price. There are generally three main scenarios that can unfold.

If the stock price is above the strike price at expiration, the option is considered “in-the-money.” In this situation, the option buyer will likely exercise their right to purchase the shares. The covered call seller is then obligated to sell their 100 shares of stock at the strike price, regardless of the higher market price. The profit for the seller in this scenario includes the premium initially received and any capital gain from the stock’s purchase price up to the strike price.

Conversely, if the stock price is below the strike price at expiration, the option is “out-of-the-money.” In this case, the option will expire worthless because the buyer would not benefit from purchasing the stock at a price higher than the market value. The covered call seller retains their 100 shares of stock and also keeps the entire premium received from selling the option. This outcome allows the investor to potentially sell another covered call against the same shares to generate additional income.

When the stock price is exactly at the strike price at expiration, it is known as “at-the-money.” The option is often more likely to expire worthless, especially if transaction costs are involved for the buyer. The covered call seller generally retains their shares and keeps the premium, similar to the out-of-the-money scenario.