What Is a Covered Call and How to Use It in Trading

A covered call is a popular trading strategy that involves selling a call option on a stock you already own. This can be a great way to generate additional income from your existing holdings.

To use a covered call, you need to own the underlying stock, which is the stock the call option is based on. This is where the "covered" part of the strategy comes in – you have a position in the stock, or it's "covered".

By selling a call option, you're giving the buyer the right to buy the stock from you at a predetermined price, known as the strike price. This can be a good way to profit from a stock that you think will remain stable or even decline in value.

The key to a successful covered call is to choose a stock that you're confident will not rise above the strike price before the option expires. If the stock price does rise, you'll be obligated to sell the stock at the lower strike price, which can limit your potential gains.

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A covered call is a unique options trading strategy that allows you to generate income by selling call options on stocks you already own. This strategy involves owning a stock and simultaneously selling a call option on that stock, creating a short call position.

The covered call strategy consists of two components: holding the underlying investment and selling the call option, which gives another investor the right to buy your stock at a predetermined price. Investors often use covered calls to generate extra income on a security that is not expected to appreciate significantly.

To execute a covered call, you need to own at least 100 shares of the underlying stock. The process begins by writing (selling) call options on the same asset you hold. The aim is to collect premium income while potentially capping the upside gains of the stock as a covered call writer.

The covered call strategy works best in a market where stock prices are relatively stable, with minor increases or decreases. It's an excellent choice if you want to generate income while holding your stock for the long term, as it provides a way to profit from anticipated price rises by selling securities at a pre-arranged price.

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The breakeven price for a covered call is calculated by subtracting the premium received from the initial underlying stock price purchase price. For example, if you own 100 shares of TSJ priced at $50 per share and receive a premium of $0.75 per share, the breakeven price would be $44.25 per share.

If the stock price stays below the strike price, the call option expires worthless, and you keep the entire premium you received and also retain full ownership of your stock. If the stock price rises above the strike price, the call option is likely to be exercised, and you must sell your stock at the agreed-upon strike price.

When selling a call option, you sell your shares at a predetermined price, known as the strike price. This action typically involves only a short call order ticket, making it a straightforward component of the covered call strategy. However, selling the call means that capital gains from holding the stock will be capped at the strike price, which is a consideration for the call option seller.

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A covered call has two main components: owning the underlying investment and selling a call option on that investment.

The underlying investment is typically a stock or ETF that you already own, which serves as collateral for the call option.

You can own the stock in advance, or you can purchase it while implementing a covered call, by doing a "buy write" or "over write" trade.

A call option is a contract that gives another investor the right to buy your stock at a predetermined price (the strike price) before a specified date (the expiration date).

Here are the two components of a covered call strategy in a nutshell:

The premium received from selling the call option can serve as additional income while holding the stock, which is particularly appealing to experienced investors looking to enhance their portfolio yield.

To execute a covered call, you need to own at least 100 shares of the underlying stock. This is a fundamental requirement of the strategy.

The process begins by writing, or selling, call options on the same asset you hold. This involves identifying a suitable stock, purchasing it, and selecting a call option at an appropriate strike price.

If the stock price stays below the strike price, the call option expires worthless. In this scenario, the seller keeps the entire premium they received.

If the stock price rises above the strike price, the call option is likely to be exercised. The seller must then sell their stock at the agreed-upon strike price.

Most options contracts are for 100 shares of stock. This means you'd make $500 selling a call option if you own 100 shares of stock and earn a $5 premium.

The strike price is a crucial factor in determining the outcome of a covered call. If the stock price is above the strike price, the seller will be obligated to sell their shares at the strike price.

Here's a summary of the possible outcomes:

The benefits of a covered call strategy are numerous, but it's essential to understand the risks involved. Limited risk is one of the key benefits, as the investor/trader owns the underlying stock and can mitigate losses if the stock's value declines. The maximum loss from a covered call is the purchase price of the stock less the premium received.

Selling covered calls allows investors and traders to generate income from the premiums received for selling the options. This can be particularly useful when one expects sideways movement in the underlying stock. The premium received can also potentially offset small losses if the stock's value drops in the period between writing the option and the expiration date.

A covered call strategy can provide some upside potential if the price of the underlying stock trades sideways or increases slightly. If the price of the underlying stock remains below the strike price of the call option, the option will expire worthless, and the investor/trader gets to keep the premium generated by selling the option(s).

The potential loss of stock ownership is a significant risk associated with covered calls. If a call option is exercised, the investor may lose ownership of the underlying stock at the strike price, which could be below the market value. This outcome can be particularly unfavorable if the investor had a long-term view of the stock and anticipated higher future gains.

Here are some key benefits and risks of a covered call strategy:

Overall, a covered call strategy can be a useful tool for investors and traders who are looking for income generation, limited risk, upside potential, flexibility, and/or diversification in their investments. However, it's essential to understand the risks and limitations of the covered call strategy.

We close covered calls when the stock price has gone well past our short call, as that usually yields close to max profit.

Closing a covered call can be a good idea if the stock price drops significantly and our assumption changes.

We roll a covered call when our assumption remains the same, that the price of the stock will continue to rise, and there is little to no extrinsic value left.

Rolling the short call allows us to collect more premium, and reduce our max loss & breakeven point.

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To execute a covered call strategy, you first need to open a brokerage account and apply for permission to trade options. This typically involves completing an options application and providing proof of trading knowledge and financial readiness.

It's crucial to choose a brokerage account with low fees, research capabilities, and robust trading functionalities. This will make it easier to navigate the options chain and make informed decisions.

Use the options chain to research different options contracts at various strike prices and durations. This will help you find the right combination of strike price and expiration date for your strategy.

The ideal time to sell covered calls is when the underlying asset has a stable to positive long-term outlook. This will help you maximize the premium you receive while minimizing the risk of the option being exercised.

To sell a call option, you need to identify the underlying stock you want to sell, determine the strike price and expiration date, and then sell the call option(s). This can be done through your trading platform, which will assist you in finding the right call option to sell.

Check this out: How to Sell Cash Secured Puts on Webull

Here's a step-by-step guide to selling a call option:

1. Identify the call option you want to sell

2. Determine the strike price and expiration date

3. Sell the call option(s)

By following these steps, you can effectively implement the covered call strategy and generate income while managing risk in your investment portfolio.

Risk management is essential when executing a covered call strategy. Effective risk management involves understanding your maximum risk, which is the potential decline in the stock's value (offset by the premium) for covered calls.

Position sizing is crucial to manage risk. Never allocate too much of your capital to a single options trade or underlying asset. Determine a maximum acceptable loss per trade relative to your portfolio size.

Strategic diversification is also vital. Don't concentrate all your option selling on one stock or sector. This can help mitigate potential losses if one stock performs poorly.

Setting profit targets and exit plans is another key aspect of risk management. Decide beforehand how much profit you're aiming for on a short option, or at what point you'll cut losses or adjust a trade that's moving against you.

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Regular monitoring of market conditions and stock prices is necessary. Keep an eye on your positions and be prepared to act if your initial thesis no longer holds or if risk levels become uncomfortable.

Here are some key risk management techniques to consider:

A covered call is a strategy that can help you generate extra income from your investments. By selling call options against the stocks you already own, you can receive a premium from the buyer, which can be a nice addition to your returns.

The key to understanding covered calls is to see them in action. For example, let's say you own 100 shares of TSJ, priced at $50 per share, and you sell a call option with a strike price of $40 for $0.75 per share. If the stock price stays below the strike price at expiration, the call option expires worthless, and you get to keep the premium.

The breakeven price for this strategy is calculated by subtracting the premium received from the initial underlying stock price purchase price. In this case, the breakeven price would be $44.25 per share.

Let's look at a real-life example. Suppose you bought 1,000 shares of ABC for $21/share and are playing the stock for a rebound. You sell 10 call contracts with a strike price of $25, receiving $360 from the sale. If the stock price falls to $20/share at expiration, you'll lose money on your long stock position, but the short call will expire worthless, and you get to keep the entire $360.

Here are some scenarios to consider:

As you can see, the outcome depends on the stock price at expiration. If the stock price stays below the strike price, you get to keep the premium and shares. If the stock price hits the strike price, you sell the shares at the strike price and keep the premium. If the stock price rises above the strike price, you sell the shares at the strike price and keep the premium.

In any case, the sale of covered calls can help you generate extra income from your investments. By understanding how covered calls work, you can make informed decisions about your investment portfolio.

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