What is a covered call?
A covered call is a special type of trading deal with options. Options are a way to buy or sell something later for a price you decide now. With a covered call, a person sells someone else the right to buy stock they already own at a certain price by a certain date. If the other person decides to use their right to buy the stock, they have to pay the price that was agreed to. This is called “exercising the option”. The person who sold the option has to sell them the stock for that price if they exercise it.
Here’s an example of how it works: Let’s say you own 100 shares of Apple stock. You decide to sell someone a “call option” that gives them the right to buy your 100 shares for $150 each anytime in the next month. The person pays you some cash for this right, let’s say $200. This cash payment is called the “premium”. After a month, if Apple stock is trading for less than $150, the call option will expire worthless. The person won’t use it because they can buy Apple stock cheaper on the market. You keep the $200 premium and your 100 shares.
But if Apple stock goes up to $160 during that month, the person will probably exercise the option to buy your shares for $150. You have to sell them your 100 shares and you get $15,000 (100 shares x $150 per share). You still keep the $200 premium too. So in total you got $15,200. But you don’t own the Apple shares anymore.
Why would you sell a covered call?
The main reason to sell covered calls is to get extra income from stocks you already own. You get paid the premium whether the option gets exercised or not. It’s cash in your pocket. Some people sell covered calls regularly to boost the income they get from their stocks. They might not sell options on all their shares though. Just some of them.
Selling covered calls is considered pretty low risk compared to other options strategies. The worst case scenario is that you have to sell your stock for the agreed price. Since you already own it, it’s not a huge deal. You still profit overall from the premium and stock sale. But you might miss out on bigger gains if the stock shoots way up and you have to sell for a lower locked-in price. That’s the trade-off.
Who buys covered calls?
On the other side, people buy call options because they think the stock price will go higher than the option price. They want the right to buy it cheaper later if they’re right. If the stock doesn’t go up past the option price, they lose the premium they paid. But their total loss is capped at the premium amount. Owning the option rather than buying shares outright lets them control more shares for less money up front. That can really boost their profits if the stock soars. They just have to be right about the direction and timing.
How to sell a covered call
If you want to sell covered calls on stocks you own, you usually do it through your broker or an options trading platform. You need an options trading account approved for that level of trading. When you enter the order, you pick which stock and how many shares you want to sell calls on. Then you choose the option expiration date and the price you’re willing to sell your shares for (called the “strike price”). You also set your minimum premium price. The trading platform will show you some common combinations of expiration, strike and premium to pick from. In general, further out expirations and lower strike prices have higher premiums.
When you enter the order, it goes into the marketplace and hopefully gets matched with a buyer. The premium cash then gets deposited in your account. The shares stay in your account too but they’re earmarked in case the option gets exercised. You keep track of your options and at expiration see if they were exercised or expired worthless. If expired, you can sell new ones to collect more premium. If exercised, the shares get called away and that’s that.
Tax treatment
One other thing to consider with covered calls is taxes. If the option never gets exercised, the premium is treated as a short-term capital gain no matter how long you’ve owned the underlying stock. But if it does get exercised, it’s like you sold the stock on that date at the strike price. Whether it’s a short-term or long-term capital gain depends on your holding period for the actual shares. So you can get a mix of short and long term depending how it plays out.
