What is a covered call?

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What is a covered call, you might be wondering? It’s actually quite simple — a covered call is an options trading strategy that allows you to generate income from stocks you already own.

By selling call options, investors can earn premiums while potentially benefiting from modest stock appreciation. On the whole, this approach is meant for traders with a neutral to slightly bullish market outlook.

What is a covered call?

A covered call involves owning a stock and selling a call option against it.⁽¹⁾

This strategy provides the option buyer with the right to purchase the stock at a specified strike price before the option expires, while the option seller earns a premium. This premium can offer downside protection and enhance returns.

However, if the stock price rises above the strike price and the buyer exercises the option, the investor may have to sell the stock at the strike price, potentially capping gains.⁽²⁾

How a covered call works

The covered call strategy blends stock ownership with options trading to generate income while managing risk.

Let’s look closer at how this options strategy works, what can happen when you execute a covered call and tie everything together with a simple, hypothetical example.

3 steps to trade covered calls

1. Buy the underlying stock or choose a stock you already own. Ensure you own enough shares to cover the call option you plan to sell. Typically, one call option contract represents 100 shares.⁽²⁾ Choose a stock with stable or slightly bullish prospects.
2. Sell a call option. Select an appropriate call option to sell, considering the strike price and expiration date. The strike price is typically set above the current market price, allowing for potential appreciation.⁽³⁾ The premium received provides immediate income.
3. Monitor your position: Track the stock price and the option’s expiration date. If the stock price remains below the strike price, the option will likely expire worthless, and you retain both the premium and the stock.⁽¹⁾ If the stock price exceeds the strike price, the option buyer might exercise their right to purchase the stock, and you may need to sell the shares at the strike price.

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Possible outcomes

Two basic outcomes can occur when writing covered calls. In the first case, the stock price remains below the strike price — then the call option expires worthless, and you retain the premium and continue holding the stock.

However, if the stock price rises above the strike price, the option buyer can exercise the option, obligating you to sell your shares at the strike price. While this caps your gains, you still benefit from the premium income and any appreciation up to the strike price.

On the whole, a covered call is quite simple to execute, making it a good options trading strategy for beginners.

Covered call example

The language surrounding trading, particularly when it comes to derivatives like options, can be a bit hard to understand at first. Let’s illustrate what we’re talking about using a simple example.

Imagine a scenario where you own 100 shares of ABC Corp, trading at $50 per share. You sell a call option with a strike price of $55, expiring in one month, for a premium of $2 per share.

Now, if ABC Corp’s stock price remains below $55, the option will likely expire worthless, and you keep the $200 premium (100 shares x $2).

If, however, the stock price exceeds $55, the buyer will likely exercise the option, and you sell your shares at the strike price. Your total profit includes the $5 gain per share (from $50 to $55) plus the $2 premium, resulting in a $7 total return per share.

Benefits of a covered call

Covered calls offer several advantages for investors looking to enhance their returns and manage risk effectively:

• Income generation. Selling call options provides investors with premium income, creating a consistent cash flow even if the stock price remains stable. This strategy can be particularly attractive in flat or mildly bullish markets where price appreciation alone might not be sufficient.
• Downside protection. The premium received acts as a buffer, offsetting minor declines in the stock price and reducing potential losses. This feature makes covered calls appealing to conservative investors seeking to protect their portfolios.
• Enhanced returns. This strategy can increase overall portfolio returns by generating additional income while maintaining stock positions for potential appreciation. Investors can capitalize on sideways markets by earning premiums while waiting for stock prices to rise.
• Reduced volatility. Earning income from premiums can smooth portfolio returns, making them more stable and less subject to large fluctuations. This stability can help create a more predictable investment outcome, appealing to risk-averse investors.

Risks and considerations

While covered calls can be beneficial, they also come with certain risks and considerations that investors should be aware of:

• Limited upside potential. Gains are capped at the strike price, which means investors miss out on larger profits if the stock price surges significantly. This limitation can be a drawback in rapidly rising markets where full stock ownership could yield higher returns.
• Stock ownership risk. A decline in the stock price can lead to losses that surpass the premium income, affecting the overall portfolio value. This risk underscores the importance of selecting stocks with stable or positive outlooks.
• Commitment to holding stock. The strategy requires investors to hold onto the stock until the option’s expiration, which may restrict flexibility in adjusting to market changes. Investors must be comfortable with the potential for opportunity costs in volatile markets.
• Market timing. Successfully selecting strike prices and expiration dates requires accurate market timing, which can be difficult to achieve consistently. Misjudging these factors can lead to suboptimal outcomes and diminished returns.
• Risk of early assignment. Investors face the possibility of early assignment, where the call option is exercised before expiration, often when dividends are declared.⁽⁴⁾ This can lead to unexpected tax implications and a need to reestablish the position at potentially unfavorable prices.⁽⁵⁾

Alternatives to covered calls

For investors seeking different strategies, several alternatives can complement or replace covered calls. Let’s take a look at three methods that are similar and easy enough to implement.

• Cash-secured puts. This strategy involves selling a put option while setting aside enough cash to purchase the stock if it falls to the strike price. Unlike regular put selling, the cash-secured approach ensures that you have the funds to buy the stock, reducing risk and providing a defined plan to acquire shares at a potentially lower cost if you’re bullish on the stock.
• Synthetic covered call. A synthetic covered call uses a combination of options — specifically, a short at-the-money (ATM) put and a long ATM call, allowing investors to achieve similar outcomes with potentially less capital while maintaining strategic flexibility.⁽⁶⁾
• Poor man’s covered call. This strategy involves buying long-term in-the-money call options and selling short-term out-of-the-money calls against these options. This combination mimics the benefits of a traditional covered call, such as generating income through option premiums, but requires less capital upfront. It’s a cost-efficient alternative for those looking to achieve similar results as a covered call strategy without owning the underlying stock. ⁽⁷⁾

When to use a covered call strategy

Covered call strategies are most effective when investors have a neutral to slightly bullish outlook on the market. This strategy is ideal for those seeking additional income from their existing stock holdings without expecting significant price increases.

Investors who prefer steady income with some downside protection can benefit from covered calls, especially if they are comfortable with limited upside potential.

It is also well-suited for income-focused investors looking to enhance returns in a low-volatility environment or those who aim to reduce portfolio volatility while maintaining stock exposure.

Bottom line

Covered calls can provide an effective way to generate income and manage risk when trading options. However, it’s important to consider your investment goals and risk tolerance before implementing this strategy.

Evaluate how covered calls fit into your overall financial plan and consult a financial advisor if needed to ensure alignment with your investment objectives.

Frequently asked questions

What is a covered call ETF?

A covered call ETF is an exchange-traded fund that implements a covered call strategy on a portfolio of stocks, generating income through option premiums.⁽⁸⁾ These funds allow investors to benefit from the covered call strategy without managing individual options themselves.

Are covered calls risky?

Covered calls involve moderate risk, primarily related to capping potential upside gains and possible stock price declines. While the premium income provides some downside protection, it’s important to assess market conditions and potential risks before executing the strategy.

What are the best stocks to sell covered calls?

The best stocks for covered calls are typically stable, blue-chip stocks with low volatility and reliable performance. Stocks with high liquidity and regular dividend payouts can also be favorable for generating consistent premium income.

Can I trade covered calls in my IRA?

Yes, many IRAs allow covered call trading, but it’s essential to check specific account rules with your broker. Ensure that your IRA account supports options trading and understand any restrictions that might apply.