Covered Calls Explained

A covered call is the most popular options strategy among income investors, and it’s the engine inside dozens of high yield ETFs. The idea fits in one sentence: you own a stock, and you sell someone the right to buy it from you at a higher price, in exchange for cash today.

How it works

1. You own at least 100 shares of a stock.
2. You sell one call option on those shares, choosing a strike price (usually above today’s price) and an expiration date (often about a month away).
3. The buyer pays you the premium immediately. It’s yours to keep, whatever happens next.

It’s called covered because you already own the shares you’ve promised to sell. If the buyer exercises, you simply hand them over. Selling a call without the shares, a “naked” call, can lose an unlimited amount and isn’t something income investors should touch.

The three ways it can end

Covered calls do best when a stock drifts sideways or rises a little. They do worst, compared with just holding, when the stock rockets, because every dollar above the strike goes to the buyer. And when the stock falls, the premium only cushions the drop. You still own the shares and take nearly the whole loss.

See the trade off

The chart compares the covered call with simply owning 100 shares. Move the strike closer and the premium grows, but the cap comes down. Move it further away and you keep more upside but collect less.

Notice the shape: the covered call line runs almost parallel to “shares only” on the left, then goes flat on the right. In plain words, you keep nearly all of the downside and give away most of the upside, in exchange for steady premium. That’s not good or bad; it’s the deal. Whether it’s a good deal depends on the price you get and what the stock does next.

The two choices you make

The strike

• At the money (near the current price): the most premium, but almost no room for the stock to rise before it’s capped.
• Out of the money (above the current price): less premium, but room for gains. Many investors pick strikes 3% to 10% above the price, or use delta (around 0.20 to 0.30) as a guide.

The expiration

Shorter options decay faster, so selling weekly or monthly options and repeating collects more premium per year than selling one long option. Many people use 30 to 45 days as a balance between income and effort. Shorter also means more trades and more chances to be caught on the wrong side of a sudden jump.

What about your dividends?

As long as you still own the shares on the ex-dividend date, the dividend is yours. Covered calls and dividend stocks pair naturally: you collect the dividend and the premium. The one catch is that a call buyer may exercise early, the day before the ex-date, to grab the dividend, if the call is in the money and the dividend is larger than the call’s remaining time value. You’ll see this in the worked example in A Covered Call From Start to Finish.

Who covered calls suit