Covered calls are one of the most popular options strategies for generating income from stocks you already own. When you sell a covered call, you collect an immediate premium in exchange for the obligation to sell your shares at a predetermined price (the strike price) if the option is exercised. The “covered” aspect means you own the underlying shares – typically 100 shares for each call option contract you sell. This strategy allows you to earn additional income on top of any dividends while potentially providing some downside protection through the premium collected.
How Covered Calls Work
When you sell a covered call, you’re granting someone else the right to buy your shares at the strike price by the expiration date. You receive premium income immediately, which is yours to keep regardless of what happens. Since you already own the shares, you’re “covered” if the option is exercised – you simply deliver your existing shares rather than having to buy them on the open market.
For every 100 shares you own, you can sell one call option contract. The key is selecting an appropriate strike price and expiration date that aligns with your goals for the position.
Possible Outcomes at Expiration
Scenario 1: Stock Price Stays Below Strike Price
If the stock price remains below your strike price at expiration, the call expires worthless. You keep the entire premium as profit and retain your shares. You’re then free to sell another covered call for additional income.
Scenario 2: Stock Price Rises Above Strike Price
If the stock price rises above your strike price, your shares will likely be called away (assigned). You’ll sell your shares at the strike price and keep the premium. Your total profit includes both the premium and any capital gain from your original purchase price to the strike price.
Example Trade
Let’s say you own 100 shares of XYZ stock that you bought at $48, currently trading at $50. You sell a weekly $52 call expiring in 7 days for a $0.40 premium:
- Shares Owned: 100 shares at $48 cost basis
- Current Price: $50
- Strike Price: $52
- Premium Collected: $40 (100 shares × $0.40)
- Return on Risk (ROR): 0.77% for 7 days ($40 / $5,200 strike value)
- Annualized ROR: 40.1% (0.77% × 52.14 weeks per year)
If XYZ stays below $52: You keep the $40 premium and your shares. That’s a 0.83% return on your $4,800 investment in one week.
If XYZ rises to $54: Your shares are called away at $52. You keep the $40 premium plus realize a $400 capital gain (sold at $52 vs $48 cost basis), totaling $440 profit.
Benefits of Covered Calls
Income Generation: Collect premium income on shares you already own, creating a regular income stream.
Downside Protection: The premium collected provides a small buffer against stock price declines.
Exit Strategy: Set a target price where you’re willing to sell, and get paid while you wait.
Enhanced Returns: Boost your overall returns beyond just stock appreciation and dividends.
Risks and Considerations
Limited Upside: Your profit is capped at the strike price plus premium, even if the stock soars past your strike.
Opportunity Cost: If assigned, you miss out on gains above the strike price and must find a new investment.
Tax Implications: Assignment may trigger capital gains taxes, potentially short-term if you’ve owned the shares less than a year.
Emotional Challenge: Watching your stock get called away during a strong rally can be psychologically difficult.
Best Practices
Choose strikes above your cost basis: Ensure you’ll have a profit if shares are called away, not a loss.
Consider your outlook: Sell calls at prices where you’re genuinely willing to sell the stock.
Monitor ex-dividend dates: Be aware that call holders may exercise early to capture dividends.
Use technical analysis: Identify resistance levels that make good strike prices.
Stay consistent: Regular weekly or monthly call selling can compound returns over time.
When to Use Covered Calls
This strategy works best when:
- You’re neutral to moderately bullish on a stock
- You want to generate income from existing holdings
- You have a price target where you’d be happy to sell
- The stock is trading in a range or moving slowly higher
- Implied volatility is elevated (higher premiums)
Rolling Positions
If your call is in-the-money near expiration and you want to keep your shares, you can “roll” the position by:
- Buying back the current call (closing the position)
- Selling a new call with a later expiration date and/or higher strike
- Ideally collecting a net credit on the roll
Rolling up and out gives the stock more room to run while extending your income stream.
The Wheel Strategy Connection
Covered calls are often paired with cash secured puts in what’s known as “The Wheel Strategy”:
- Sell cash secured puts to potentially acquire shares at a discount
- If assigned, sell covered calls on those shares
- If shares are called away, return to selling puts
- Repeat the cycle for consistent income
Assignment and Early Exercise
While most options are exercised at expiration, American-style options can be exercised early. This typically happens when:
- A call is deep in-the-money near expiration
- The stock is about to pay a dividend
- There’s very little time value remaining
Be prepared to have your shares called away at any time once your call is in-the-money.
Tax Considerations
Covered call premiums are typically taxed as short-term capital gains. If your shares are called away, the premium is added to your sale price for calculating capital gains. The holding period of your shares determines if the stock sale is taxed as long-term or short-term capital gains. Special rules apply for “qualified covered calls” – consult a tax professional for your specific situation.