What are covered calls and how do they work?

Investing can seem like a maze of strategies, terms and techniques – especially when you’re just starting out.

One strategy often employed by experienced investors looking to generate extra income is the covered call.

Some investors use covered calls to make money on a security they believe will not appreciate in value very much over a specific time frame. As with any options-trading strategy, there are benefits and risks you should take into account.

Covered calls might seem complicated, but for the more advanced investor, it may be effective strategy as long as its implications are fully understood along with the risks involved.

How does a covered call work?

A covered call is when you own 100 shares of a stock and sell (write) a call option against those shares. You collect an upfront premium payment for selling the option, but agree to sell your shares at the strike price if the stock rises above the level before expiration. It’s like getting paid to set a sell order above the current price, with your owned shares acting as collateral.

Here are the steps involved when you’re selling covered calls:

Gain ownership of the security

With options trading, you don’t necessarily have to buy the shares outright. Instead, you agree to buy them at a certain price. If you’re going forward with a covered call though, you do need to own the shares, and must own at least 100 shares. Owning the security (that’s why it’s called “covered”), such as shares of a company or an exchange traded fund (ETF), is the first step in a covered call.

Sell a call option

Next, you sell a call option on that security. Setting a call option gives other buyers the right (but not the obligation) to purchase shares from you at a specific price, known as the strike price, within a particular period of time. When you sell this option, you’re entering into an agreement that you may have to sell your shares at the strike price should the buyer decide to exercise the option.

Collect the premium

The money you collect for selling that covered call is called the premium.

This is an upfront payment the buyer makes to you for the opportunity to purchase your stock at the strike price. Regardless of how the price of the stock fluctuates, the premium is yours to keep.

Monitor the option

Before the expiration (or exercise) date of the call option, you have the flexibility to buy back the option if you decide to close the position early. If the stock declines, for example, you might use this as a risk management strategy.

Expiration or exercise

When the option period concludes – on the exercise date – one of two scenarios will occur:

Here’s how a covered call works in practice

Here’s an example to illustrate how a covered call strategy works.

Let’s say you own 100 shares of ABC Company that you bought at $200 a share. You believe that the shares will trade flat or slightly higher in the near future. You sell a covered call with an expiration in three months, with a premium of $2 per share, with a strike price of $215 (giving you an obligation to sell the shares at $215).

Two scenarios could play out:

Scenario 1: Stock price below $215 (strike price) at expiration date

If ABC’s stock is trading at $210 per share at the expiration date, the call option expires worthless. The buyer won’t exercise their right to buy at $215, and you keep your 100 shares of ABC as well as the premium, which amounts to $200.

Scenario 2: Stock price above $215 (strike price)

If ABC’s stock has risen to $220 per share before the option’s expiration date, the buyer will likely exercise their option to purchase shares at $215. You’ll sell your shares at $215 per share and keep the premium, which amounts to $200.

While you won’t benefit from the full $220 market price, your total profit includes the premium and any gains between your purchase price ($200) and the strike price ($215).

Overall, this strategy works best in markets where you expect limited upside for the stock as the strike price caps your profit, but the premium helps supplement your returns.

How do you manage your maximum profit and maximum loss?

When you’re engaging in a covered call strategy, understanding your potential maximum profit and maximum loss is a key component.

The maximum profit you can make is the sale price at the strike price plus the premium you collect from selling the call minus your cost basis (the price you paid for the security).

Essentially, you're capping your potential upside because the covered call obligates you to sell the shares at the strike price, even if the stock's market price exceeds it.

On the flip side, the maximum loss can occur if the underlying security loses significant value before the call option’s expiration date. The premium you collected from the sale of the call might offset this loss somewhat, but beyond the premium, your exposure to loss can be substantial if the security takes a large dip while you you’re holding an unexpired call option.

This dynamic makes a covered call strategy ideal for those seeking additional income in a fairly stable market environment.

Potential pros and cons of covered calls

For experienced investors, covered calls may be a smart play in some situations, but they’re not without their trade-offs. At the end of the day, whether this strategy is for you depends on your risk tolerance and financial goals, how experienced you are as an investor, as well as how hands-on you want to be with your portfolio.

Like everything in investing, success comes down to knowing how to get the best possible return on an  investment while avoiding excessive risk.

Here are some potential pros and cons to consider about this investing strategy.

Pro: Ability to generate a return on investment with the premium

One of the clearest upsides to selling covered calls is that you can usually collect the premium.

If the market price goes above the strike price, you can sell your shares and make a profit and keep the premium. If the market price stays below the option’s strike price, you can keep the premium, and your shares stay untouched.

Pro: Potential tax benefits

For some investors, selling covered calls might trigger tax benefits. If a call option is exercised and the owner has a long-term holding period they could potentially enjoy long-term capital gains treatment on the premium. You may want to make sure that you’re working with a qualified tax professional to make sure that your profits and losses are properly represented on your taxes if you’re looking to reap potential tax benefits from this investing strategy.

Con: Capped upside potential

While covered calls might sound like a good way to trade options, they’ve got a downside, too – namely, they limit how much you can profit from a stock.

Say your stock shoots up well beyond the strike price of the call option you sold. Instead of cashing in on those sky-high gains, you’re left selling your shares at the agreed-upon strike price. It’s the financial equivalent of hitting the brakes just as you’re getting up to speed.

You may be okay with locking in that upfront premium and a capped level of profit. But, if you’re aiming for a higher return on investment and can accept greater risk, a covered call strategy may be limiting.

Con: No protection against losses

Covered calls don’t protect you when things go south. If the underlying stock starts tanking before you option has expired, you’ll be left holding the bag, unable to sell the stock unless you close your option position.

You’ll have the premium from the options sale to soften the blow, but it rarely balances out substantial losses in the stock itself. For most beginner investors, a covered call isn’t the safety net they might wish it could be.

Con: Requires active management

When it comes to covered calls, you can’t just set it and forget it. Writing covered calls successfully means keeping an eye on your stock’s performance, the options’ expiration period and market trends.

For traders who don’t enjoy keeping a close eye on their portfolios, this level of active management required might feel like more hassle than it’s worth.

When do covered calls make sense for investors?

Covered calls can be suitable for investors in specific scenarios. Here are a few of them:

For those looking to collect income on their security holdings

If you’re wanting to generate consistent income from your stock holdings, selling covered calls may provide consistent income via premiums. Even if the market price doesn’t reach the strike price, you gain income from the premium while retaining your shares.

When the market is somewhat bullish or neutral

Covered calls thrive in markets with little volatility or steady upward trends. If the stock price hovers near or below the strike price, you can potentially repeatedly generate premium income while holding on to your shares.

This situation enhances your potential to extract income in market conditions that lack rapid fluctuations.

For those okay with selling the stock at a target price

Sometimes, you may already have a target price in mind to sell your shares. Covered calls may be helpful in this scenario, as they allow you to obtain income while waiting for your stock to hit your desired price range.

Should the stock reach the strike price, you earn your target value plus the premium, making it a strategic exit option.

When do covered calls not make sense for investors?

While covered calls can be a useful strategy, they come with inherent risks that require careful consideration before execution.

You are not protected against loss

Covered calls provide no protection for downside risk. If your security’s market value drops steeply, your losses can exceed any income you earned from the premium. The strategy doesn’t cover declines in the stock price, which means you remain fully exposed to losses from poor market performance or company issues.

Risk from not being able to manage holdings freely

By engaging in a covered call, you limit your ability to sell or manage your stock holdings freely. Since those shares are tied to the call option, selling or making other adjustments without closing out the option isn't possible, which reduces trading flexibility.

The bottom line

Covered calls are highly situational tools that work for investors who are content with limiting their upside for the sake of income stability in a relatively stable market environment.

They do come with very real risks to consider, and may require active monitoring, which is a consideration to make if this is a strategy you’re consider employing.

Carefully assess your risk tolerance, goals and willingness to trade flexibility for income when considering covered calls in your investment approach. Consider consulting with a financial advisor for an even more personalized approach.

View Disclosures