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Covered Call Strategy

A covered call involves selling a call option on a stock you already own, generating premium income while capping upside potential.

The covered call is one of the most popular options strategies for income-focused investors. You buy 100 shares of a stock and simultaneously sell one call option contract against those shares. The premium collected provides immediate income and a modest downside cushion. In exchange, you agree to sell your shares at the strike price if the option is assigned, capping your upside above that level.

Consider an investor who owns 100 shares of AAPL at $180. They sell a $190 call expiring in 45 days for $3.50 per share ($350 total). If AAPL stays below $190, they keep the $350 premium and their shares. If AAPL rises above $190, they may be assigned and sell shares at $190, still profiting from the $10 per share gain plus the $3.50 premium, for a total return of $13.50 per share, or 7.5% in 45 days.

Selecting the Right Strike and Expiration

The strike price determines your risk/reward profile. Selling an at-the-money call generates higher premium but caps upside immediately. Selling an out-of-the-money call offers less premium but allows for more upside appreciation. The expiration cycle also matters: weekly options offer quick premium decay but require frequent management, while monthly or LEAPS options provide more premium per trade but tie up capital longer. Many covered call writers target 30-60 days to expiration and strikes 2-5% above the current price to balance income with upside potential.

Tax Implications

Covered call premiums are treated as short-term capital gains if the option is opened and closed within a year. If the option is assigned and shares are called away, the total gain (stock appreciation plus premium) is treated as a capital gain. Short-term gains are taxed at ordinary income rates. Be aware of the qualified covered call rules under Section 1258 of the Internal Revenue Code, which can affect holding periods for favorable long-term rates on the underlying shares.

FAQs

What happens if the stock drops sharply?

The covered call provides a small buffer equal to the premium received. If AAPL drops from $180 to $170, the $3.50 premium reduces the effective loss to $6.50 per share. The option will likely expire worthless, and you keep the premium.

Can I close the covered call early?

Yes. You can buy back the call option at any time before expiration. This is common when the stock has rallied and you want to capture further upside, or when you want to realize gains on the option position.

Is a covered call the same as a buy-write?

Yes. A buy-write is simply entering the stock purchase and call sale simultaneously. A covered call can also be established by selling a call against shares already held. Both are functionally identical.

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