The Basics of Covered Calls

What Is a Covered Call?

A covered call is an options trading strategy where an investor sells call options on a stock they already own. Professional market players write covered calls to boost investment income. Individual investors can also benefit from the conservative but effective covered call option strategy by taking the time to learn how it works and when to use it.

How a Covered Call Works

You're entitled to several rights as a stock or futures contract owner, including the right to sell the security at any time for the market price. Covered call writing sells this right to someone else in exchange for cash. The buyer of the option gets the right to purchase your security on or before the expiration date at a predetermined price called the strike price.

A call option is a contract that gives the buyer the legal right but not the obligation to buy shares of the underlying stock or one futures contract at the strike price. They can do so at any time on or before expiration. The option is considered "covered" if the seller of the call option also owns the underlying security because they can deliver the instrument without purchasing it on the open market at possibly unfavorable pricing.

Covered Call Visualization

The horizontal line in this diagram is the security's price. The vertical line is the profit or loss potential. The dots on the profit or loss potential line indicate the amount of profit or loss the covered call seller might experience as the price moves.

The seller would break even on the horizontal price line when the price intersects a profit or loss potential of zero. The contract seller will likely set the strike price at the point where they think the price will intersect the profit potential limit, indicated by the blue dot on the price line.

Profiting From Covered Calls

The buyer pays the seller of the call option a premium to obtain the right to buy shares or contracts at a predetermined future price called the strike price. The premium is a cash fee paid on the day the option is sold and it's the seller's money to keep regardless of whether the option is exercised.

A covered call is therefore most profitable if the stock moves up to the strike price, generating profit from the long stock position. Covered calls can expire worthless unless the buyer expects the price to continue rising and exercises, allowing the call writer to collect the entire premium from its sale.

The call seller will sell the shares at the strike price and keep the premium if the covered call buyer exercises their right, profiting from the difference in the price they paid for the share and the selling price plus the premium. But the seller gives up the opportunity to profit from further share price increases by selling the share at the strike price.

When to Sell a Covered Call

You get paid in exchange for giving up a portion of future upside when you sell a covered call. Assume you buy XYZ stock for $50 per share, believing it will rise to $60 within one year. You're also willing to sell at $55 within six months, giving up further upside while taking a short-term profit. Selling a covered call on the position might be an attractive strategy in this scenario.

The stock's option chain indicates that selling a $55 six-month call option will cost the buyer a $4 per share premium. You could sell that option against the shares that you purchased at $50 and hope to sell at $60 within a year. Writing this covered call creates an obligation to sell the shares at $55 within six months if the underlying price reaches that level. You get to keep the $4 in premium plus the $55 from the share sale for a total of $59 or an 18% return over six months.

But you'll incur a $10 loss on the original position if the stock falls to $40. The buyer won't exercise the option because they can buy the stock cheaper than the contract price. You get to keep the $4 premium from the sale of the call option, however, reducing the total loss from $10 to $6 per share.

Advantages of Covered Calls

Covered calls provide a way to enhance the yield on a portfolio by collecting premiums from selling call options. This extra income can supplement dividends or other forms of income generated by the stock holdings, potentially increasing overall returns.

Covered calls can also serve as a means to generate income while waiting for the stock to appreciate or stabilize in stagnant or slightly bearish market conditions when stocks may not be experiencing significant price appreciation.

Covered calls can act as a form of downside protection. Investors effectively lower their cost basis in the underlying stock by receiving the premium from selling the call option. The premium received can offset some of the losses or provide a cushion against downside risk if the stock price remains flat or decreases slightly.

The seller earns less return than if they held the stock if XYZ stock in the example closes above $59. But the seller makes more money or loses less money than if the options sale hadn't taken place if the stock ends the six-month period below $59 per share.

Risks of Covered Calls

Call sellers have to hold onto underlying shares or contracts or they'll be holding naked calls that theoretically have unlimited loss potential if the underlying security rises. Sellers must therefore buy back options positions before expiration if they want to sell shares or contracts, increasing transaction costs while lowering net gains or increasing net losses.

Another risk of covered calls is the potential for loss if the stock price declines. The premium received from selling the call option provides some downside protection but it may not fully offset losses if the stock price decreases significantly. The investor may incur losses on the stock position if the stock price falls below the breakeven point, the original purchase price minus the premium received.

The Bottom Line

You can use covered calls to decrease the cost basis or to gain income from shares or futures contracts. You're adding a profit generator to stock or contract ownership when you use one.

Like any strategy, covered call writing has advantages and disadvantages. Covered calls can be a great way to reduce your average cost or generate income if they're used with the right stock,

Disclosure: Investopedia does not provide investment advice. This information is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor, and it might not be suitable for all investors. Investing involves risk, including the possible loss of principal.