Covered Call
Definition
An options strategy where you sell call options on stock you already own, generating premium income in exchange for capping your upside potential if the stock rises above the strike price.
A covered call is the most popular options income strategy. If you own 100 shares of a stock at $50 and sell a $55 call option for $2, you collect $200 in premium. If the stock stays below $55 at expiration, you keep both the shares and the premium. If it rises above $55, your shares are sold at $55 — you miss upside above $55 but still profited from the stock gain plus premium.
The "covered" in covered call means you own the underlying stock, so if the option is exercised, you simply deliver shares you already have. This is much less risky than selling a "naked" call without owning the stock, which has theoretically unlimited risk.
Covered calls work best in flat to moderately bullish markets. In a flat market, the premium income adds to your return. In a moderately rising market, you profit from both stock appreciation (up to the strike) and the premium. The strategy underperforms in strongly rising markets (you miss upside) and doesn't protect against declines (premium offsets only a small portion of losses).
The strategy is popular among income-focused investors and retirees who want to generate additional cash flow from their stock holdings. Writing covered calls on dividend stocks can create a "triple income" stream: dividends, premium income, and potential capital appreciation up to the strike.
Tax treatment of covered calls depends on whether they expire, are bought back, or are exercised. Expired and bought-back premiums are short-term capital gains. Exercised calls affect the sale price of the underlying stock. The interactions between covered calls and the holding period of the underlying stock can be complex.
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Frequently Asked Questions
How much income can covered calls generate?
Typical annual returns from covered call writing are 5-12% of the stock's value, depending on the stock's volatility (higher volatility = higher premiums). Combined with dividends, a covered call strategy can generate 7-15% annual income. The tradeoff is capped upside during strong rallies.
What are the risks of covered calls?
The main risk is opportunity cost — if the stock surges past your strike price, you miss the upside. The stock can still decline (the premium provides only a small cushion). You may also have your shares called away at an inopportune time, potentially triggering taxes. The premium doesn't protect against significant downside.