Options Trading: Covered Call Strategy Basics

Choosing and executing a covered call strategy can be like driving a car. There are several moving parts, but once you've learned the specifics—and become aware of the potential pitfalls—you can steer toward your objective. Trade enough covered calls, and it, like driving, can become second nature (though never without risk). 

A covered call gives an option buyer the right to purchase stock shares an option seller already owns (hence, "covered") at a specified strike price and at any time on or before the specified expiration date. Selling covered calls is a popular tactic among traders looking to earn income on stocks they already own. But selling (or "writing") covered calls has other potential uses that many investors may not fully realize. 

Let's pop the hood and look at three features—and risks—of this basic options strategy: selling stock, collecting dividends, and potentially limiting taxes.

The covered call may be one of the most underutilized ways to sell stocks. Traders who already plan to sell at a target price might consider selling a covered call to collect additional income in the process.

Let's say ZYX stock is trading at $23 per share, and the stock owner wants to sell their 100 shares at $25. While they could sell the shares at $23 right now, they could also sell a covered call at the $25 strike price and collect the call premium while waiting for the stock to (hopefully) increase. 

When the trader sells the call, they'll receive the premium, which is immediately deposited into their account (minus transaction costs). The trader keeps this cash no matter what happens to the underlying shares. 

If ZYX rises above $25 at any time until the option expires, the trader may be assigned on the short option, and the shares of ZYX will be called away, or sold, at the strike price. As intended, the trader has sold their stock for $25 per share but also received a premium for selling the call. 

If the stock moves higher than $25, the trader reached their goal but won't benefit from any moves above this price because they agreed to sell ZYX at $25. They pocketed the call premium and collected the appreciation from $23 (the original stock price at the time of the covered call trade) to $25. But they miss out on any stock appreciation from here. 

It's also possible for the stock price to fall from $23 to $20, or perhaps even lower. In this case, the trader would keep the premium received and still own the stock at expiration. But now they're looking at a potential loss in the stock position (depending on the price at which they originally bought ZYX). There is some downside protection with this strategy, but it's limited to the cash received when the option was sold.

Tip: Whenever a covered call option is at the money (ATM) or in the money (ITM), the stock could be called away, even ahead of expiration. In fact, the deeper the option is ITM during the options contract's lifetime, the higher the probability that the stock will be called away and sold at the strike price. And if the option is ITM by even one penny when expiration arrives, the stock will be called away, so it's essential to keep a close eye on positions as expiration nears.

Selling covered calls can feel like a triple play when everything goes according to plan. Covered call sellers collect a premium, can receive dividends on the held stock (if applicable), and keep any potential capital gains on the underlying stock (up to the sold strike price). 

On the other hand, the option buyer may also want to earn the dividend, so as a stock's ex-dividend date approaches, the chance the stock will be called away increases. Remember, the option buyer has the right to call the stock away at any time. The call seller keeps the premium and any capital gains up to the strike price but risks missing out on a dividend payment if the stock is relinquished before the ex-dividend date. 

Tip: If the option is deep ITM, there's a higher probability the stock will be called away before the ex-dividend date. Anytime a trader sells a call on a stock they own, they must be prepared for this possibility. Though early exercise could happen at any time, the likelihood grows as the stock's ex-dividend date approaches. 

There may be tax advantages to selling covered calls within an individual retirement account (IRA) or other retirement account where premiums, capital gains, and dividends may be tax-deferred. However, there are exceptions to this, so consult a tax professional to discuss your personal circumstances.

If the stock is held in a taxable brokerage account, there are some tax considerations. For example, a trader holding ZYX stock at a profit in November may not want to sell the shares for tax reasons. Instead, they could write a covered call with a January expiration date. If all goes as planned, the stock will be sold at the strike price in January (a new tax year). Of course, there is still the risk, no matter how small, that the option will be assigned sooner than expected, as well as a risk that the stock may fall and never reach the intended strike price. 

Some traders believe the benefits of selling covered calls outweigh the risks and may even evaluate future stock investments through this lens. If an equity is viewed as a good candidate for the covered call strategy, traders can execute a buy-write by simultaneously buying the underlying stock and selling (writing) a covered call.

Like driving, even basic options strategies, such as covered calls, require education and practice. And any approach to trading should align with the individual trader's investment goals, financial situation, and overall risk tolerance.