What Is a Covered Call and How Does the Strategy Work?
Master the covered call strategy. Learn how to generate income and manage risk using your stock portfolio.
Options trading offers investors flexible strategies to manage portfolios and pursue financial goals. Among these, the covered call is a popular and conservative choice. It is often used by investors seeking to generate additional income from their existing stock holdings.
Defining a Covered Call
A covered call is an options strategy where an investor owns at least 100 shares of a stock and sells one call option contract against those shares. The term “covered” means the investor already possesses the underlying stock, providing collateral if the option is exercised.
The strategy involves two components: the underlying stock and the call option. The stock provides coverage for the call option. The call option is a contract giving its buyer the right to purchase the stock from the seller at a predetermined strike price on or before an expiration date. When selling this option, the investor receives an upfront payment, called the premium, which is the core income component.
How a Covered Call Operates
When an investor sells a covered call, they collect the option premium immediately. This premium compensates for the obligation to sell shares if the option buyer exercises their right. The premium provides a buffer against stock price decline.
Two scenarios can unfold by the option’s expiration date. If the stock’s price remains below the strike price at expiration, the option will likely expire worthless. The investor keeps the premium and retains ownership of their shares, allowing them to sell another covered call.
Conversely, if the stock’s price rises above the strike price by expiration, the option buyer will likely exercise their right, and the investor’s shares will be “called away” at the strike price. The investor keeps the premium, but profit from stock appreciation is limited to the strike price plus the premium received.
For tax purposes, the premium is generally not recognized as income until the option expires worthless, is closed, or is assigned. If the option expires worthless, the premium is typically treated as a short-term capital gain. If the option is exercised, the premium is added to the strike price to determine the stock’s sale price, influencing the capital gain or loss. The stock’s holding period determines if the gain or loss is short-term or long-term.
Key Factors for Consideration
Selecting the strike price impacts the premium received and the likelihood of shares being called away. An out-of-the-money (OTM) call, significantly above the current stock price, results in a lower premium and lower probability of being called away. A strike price closer to or below the current stock price (at-the-money or in-the-money) yields a higher premium but increases the chance of shares being sold. Investors often choose a strike price at which they would be comfortable selling their shares.
The expiration date also plays a role. Shorter-duration options have less time value, which decays faster as expiration approaches, benefiting the seller. While shorter-term options offer quicker premium collection, they may require more frequent management. Longer-term options provide more substantial premiums but expose the position to market fluctuations longer. Many investors prefer options expiring within 20 to 50 days to balance premium generation and management.
Market volatility influences the premium received. Implied volatility, reflecting market expectations of future price movements, directly impacts option prices. Higher implied volatility leads to higher option premiums, offering greater income potential. However, increased volatility also suggests a higher probability of significant price swings, which could lead to the option being exercised or the stock declining.
Dividends also impact covered calls. If the stock pays a dividend before expiration and the option is in-the-money, there is an increased risk of early exercise by the option buyer. This often occurs when the dividend amount exceeds the option’s remaining time value, as the buyer may exercise to capture the dividend. Covered call writers should be aware of ex-dividend dates to anticipate early assignment.
Placing a Covered Call Trade
Executing a covered call trade begins by logging into a brokerage account approved for options trading. An investor navigates to the options trading section, which provides access to an option chain for specific stocks. This chain lists available call and put options, their strike prices, expiration dates, and current premiums.
The next step involves identifying the specific call option contract to sell. This selection is based on the chosen strike price and expiration date, aligning with the investor’s strategy. After selecting the contract, the investor chooses “Sell to Open” as the action, indicating a new short option position.
The quantity of contracts to sell is then specified; one option contract represents 100 shares. Using a limit order is common practice, allowing the investor to set the minimum premium they are willing to receive. After reviewing order details, the trade is submitted for confirmation. Some platforms offer a “Buy Write” order type, which simultaneously executes the purchase of shares and the sale of the covered call option.