Editor's Note: Options are not suitable for all investors. Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Please see the Characteristics and Risks of Standardized Options.
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With most things in life, it helps to be covered — by a coworker, an insurance policy, or a roof over your head. In investing, it can also be helpful to have coverage through specific strategies. A covered call is an options trading strategy that involves selling call options on stocks you already own, with the goal of potentially generating income.
Here’s a breakdown of how a covered call strategy works, when to consider it, and how it may — or may not — perform depending on market positions.
Key Points
• A covered call strategy involves selling call options on owned assets to try to generate income, with limited upside if the stock’s price surges.
• Using covered calls may provide additional income from stock holdings through the premiums received.
• Premiums from covered calls may offer limited protection against stock price declines, which could help offset potential losses.
• Capped gains risk occurs if the stock price rises sharply above the call option’s strike price.
• Employing covered calls restricts the ability to sell stocks freely, as the call option must be honored if exercised.
What Is a Covered Call?
A covered call is an options trading strategy used to generate income by selling call options on a security an investor already owns. This strategy can be beneficial to the investor if they expect the stock’s price to experience limited movement or remain neutral, though it may limit potential gains if the stock rises sharply above the strike price.
Call Options Recap
A call is a type of option that gives purchasers the right, but not the obligation, to buy shares of an underlying asset or stock at a specific, prearranged price, called the strike price. A call is in contrast to a put option, which gives buyers the right, but not the obligation, to sell the underlying asset at the strike price.
An investor who purchases a call option holds a long position in the option — that is, they anticipate that the underlying stock may appreciate. For example, an investor who anticipates a stock’s price increase might buy shares, hold them, wait for appreciation, and — assuming they do appreciate — sell them to potentially realize a gain.
Call options allow options buyers to pursue a similar strategy without buying the underlying shares. Instead, a premium is paid for the right to buy the shares at the strike price, allowing buyers to profit if the market price rises above the strike price.
Call option writers (or sellers), on the other hand, typically sell call options when they anticipate that the price of the underlying asset will decline, allowing them to keep the premium, or price paid for the option, when the option expires worthless.
What’s the Difference Between a Call and a Covered Call?
The main difference between a regular call and a covered call is that a covered call is “covered” by an options seller who holds the underlying asset. That is, if an investor sells call options on Company X stock, it would be “covered” if they already own an equivalent number of shares in Company X stock. Conversely, if an investor does not own any Company X stock and sells a call option, they’re executing what’s known as a “naked” option, which carries a much higher risk because losses can theoretically be unlimited if the stock rises sharply.
In a covered call, the seller’s maximum profit is limited to the premium plus any stock appreciation up to the call’s strike price, while the maximum loss equals the price paid for the stock minus the premium received. This same structure can be helpful to clarify gains and losses.
It’s worth noting that losses, overall, could be substantial if the price of the stock purchased falls to zero and becomes worthless, though the premium received from the call option sold may cushion the loss to a certain extent.
Example of a Covered Call
The point of selling covered calls is typically to generate income from existing stock positions. If, for example, you have 100 shares of Company X stock and were looking for ways to pursue additional income, you might consider selling covered calls to other investors.
Here’s what that might look like in practice:
Your 100 shares of Company X stock are worth $50 each or $5,000 at the current market value. To make a little extra money, you decide to sell a call option with a $10-per-share premium at a strike price of $70. Since standard options contracts typically represent 100 shares, you receive a total of $1,000 for the option.
Let’s say that Company X stock’s price only rises to $60, and the buyer doesn’t exercise the option, so it expires. In this scenario, you’ve earned a total of $1,000 by the selling covered call option, and your shares have also appreciated to a value of $6,000. So, you now have a total of $7,000.
The ideal outcome in this strategy is that your shares rise in value to near the strike price, (say, $69) but the buyer doesn’t exercise the option. In that scenario, you still own your shares (now worth $6,900) and get the $1,000 premium.
But the risk of selling covered call options is that you might forgo higher gains if the stock significantly exceeds the strike price.
So, if Company X stock rises to $90 and the call buyer executes their option, you would then be obligated to sell your 100 shares, which are now worth $9,000 on the open market. You would still get the $1,000 premium, plus the value of the shares at the predetermined strike price of $70 (or $7,000) — bringing the total trade value to $8,000. Effectively, you’ve turned a holding valued at $5,000 into $8,000, though doing so caps your upside and forfeits potential gains beyond the strike price.
On the other hand, had the covered call never been initiated, your shares could be worth $9,000. This illustrates the trade-off involved in selling covered calls: capped upside in exchange for income.
Recommended: How to Sell Options for Premium
When and Why Should You Do a Covered Call?
There is no single correct time to use a covered call strategy — it depends on weighing potential risks and evaluating the market environment.
Some investors may choose to write covered calls when the market is expected to climb moderately — or at least stay neutral. Since market outcomes are uncertain, investors should be ready and willing to sell their holdings at the agreed strike price.
As for why an investor might use covered calls? The goal is often to generate income from existing stock holdings. Another potential reason to use covered calls, for some investors, is to offset some risk using the premium received.
Pros and Cons of Covered Calls
Using a covered call strategy could serve specific purposes for income generation or risk management. But there are pros and cons to consider.
Covered Call Pros
The benefits of utilizing covered calls include the potential to receive added income and offset downside risk.
• Investors can potentially pad their income by keeping the premiums they earn from selling the options contracts. Depending on how often they sell covered calls, this can lead to recurring income opportunities.
• Investors can determine an adequate selling price for the stocks that they own. If the option is exercised, an investor can potentially realize a profit from the sale (as well as the premium).
• The premium the investor receives for the sold call can potentially help offset a potential decline in a stock’s price. This provides limited downside protection, though losses can still occur.
Covered Call Cons
There are also a few drawbacks to using a covered call strategy:
• Investors could miss out on potential profits if a stock’s price rises, and continues to rise, above the strike price. This is an inherent trade-off of the strategy. There is also the risk that the option is exercised and the investor must sell a stock — although, investors should typically only consider covered calls for assets that they’re prepared to sell.
• An investor may be unable to sell their stocks on the market if they’ve written a call option on the shares. This limits the investor’s flexibility to respond to price movements.
• Investors need to keep in mind that covered call gains may be subject to capital gains taxes.
The Takeaway
A covered call may be attractive to some investors as it’s a way to potentially generate additional income from a stock position. That said, as with all trading strategies, outcomes may vary based on market conditions and timing. There are no guarantees, and the strategy involves trade-offs between income potential and capped gains.
SoFi’s options trading platform offers qualified investors the flexibility to pursue income generation, manage risk, and use advanced trading strategies. Investors may buy put and call options or sell covered calls and cash-secured puts to speculate on the price movements of stocks, all through a simple, intuitive interface.
With SoFi Invest® online options trading, there are no contract fees and no commissions. Plus, SoFi offers educational support — including in-app coaching resources, real-time pricing, and other tools to help you make informed decisions, based on your tolerance for risk.
FAQ
Are covered calls free money?
Covered calls are not “free money.” They may generate income if the option expires worthless, but they can also limit upside potential if the stock’s value increases significantly or the option is exercised when the price rises toward the strike.
Are covered calls profitable?
Covered calls may be profitable, but results depend on the performance of the underlying stock and the terms of the option contract. If the option expires unexercised, the seller keeps the premium and the stock. The strategy tends to work best in neutral to moderately bullish markets, and profitability can depend on strike selection and timing.
What happens when you let a covered call expire?
If a covered call expires without being exercised, nothing happens: the option just expires worthless. The seller keeps the premium received, which can be a benefit of the strategy. Because an option is only that — an option to execute a trade at a predetermined price for a select period of time — the option holder’s reluctance to execute during the time period means that the option will expire worthless.
Can you make a living selling covered calls?
Living strictly off income from covered calls may be theoretically possible, but it would likely require a large portfolio to make it work. There are other factors to consider, too, like potential capital gains taxes and the fact that the market won’t always be in a favorable environment for the strategy to work.
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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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