Options strategies
Covered calls, explained
Selling a call against shares you own brings in cash now in exchange for capping your upside. How it works, what can happen by expiration, and the risks that remain.
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What a covered call is
A call option gives its buyer the right, but not the obligation, to buy 100 shares of a stock at a set price (the strike) until a set date (the expiration). Whoever sells the call takes on the matching obligation: if the buyer exercises, the seller must deliver the shares at the strike.
A covered call is selling one call for every 100 shares you already own. The shares “cover” the obligation: if you have to deliver them, you already have them. In return you receive the option’s price, called the premium, as cash in your account straight away.
The trade-off is simple to state. You get paid now, and in exchange you give up any gain above the strike until the option expires. You still own the shares, so you still carry almost all of the risk if the price falls.
A worked example
Example
Selling a call against 100 shares
Suppose you own 100 shares of a stock that trades at $100, and you bought them at $100. You sell one call with a $105 strike that expires in 30 days.
With implied volatility (IV) of 30%, a 4% interest rate and no dividend, the Black-Scholes model values that call at about $1.66 a share, so you’d collect about $166 for one contract, before fees. Real market prices sit around the model value, between the bid and the ask.
- Most you can make by expiration: $5 a share from the stock rising to the strike plus the $1.66 premium, or about $666.
- Breakeven: $100 − $1.66 = $98.34. Below that, the position loses money.
- Most you can lose: about $9,834, if the stock went to zero. The premium only softens the loss on the shares.
The $166 is about 1.7% of the shares’ value for 30 days. That can look attractive when annualized, but an annualized figure assumes you could repeat the same trade, with the same result, all year.
What can happen by expiration
| Stock at expiration | Shares alone | Shares + covered call |
|---|---|---|
| $90 | −$1,000 | −$834 |
| $95 | −$500 | −$334 |
| $100 | $0 | +$166 |
| $105 | +$500 | +$666 |
| $115 | +$1,500 | +$666 |
- The stock stays below $105. The call expires worthless. You keep the premium and the shares, and can decide what to do next.
- The stock finishes above $105. The call is almost certainly exercised and your shares are sold at $105. You keep the premium, but any rise above $105 goes to the call buyer. At $115 that is $1,000 of gain you gave up.
- The stock falls. You keep the premium, which offsets part of the loss, but you still own shares that are worth less.
The risks: capped upside and the stock can still fall
Risk
What a covered call doesn’t protect you from
The premium is small compared with the value of the shares. If the stock drops 20%, a 1–2% premium barely changes the result. A covered call is not a hedge against a large fall.
- Capped upside: in a strong rally you sell at the strike and miss the rest. Over time, the trades where the stock jumps can cost more than the premiums you collected.
- You may lose shares you wanted to keep. If the stock finishes above the strike, it is sold. Buying it back later may cost more, and selling can create a taxable gain.
- Buying back the call costs money. If you want to keep the shares after the stock rises, you can close the call before expiration, but it will cost more than you received.
- Selling a call below what you paid for the shares can lock in a loss on them if they’re called away.
Assignment, including early assignment
When a call buyer exercises, a seller is assigned and must deliver the shares. Most US stock options are American-style, which means they can be exercised on any business day before expiration, not only at the end.
Early exercise is uncommon while a call still has meaningful time value, because the buyer would throw that value away. It becomes more likely when the call is deep in the money with little time value left, and especially the day before an ex-dividend date: a call buyer may exercise to own the shares in time to collect the dividend. If that happens, you deliver the shares and don’t receive the dividend.
Calls that finish in the money at expiration, even by a cent, are usually exercised automatically. Plan as if you’ll be assigned whenever the stock is above the strike near expiration.
Choosing a strike and expiration
Every choice trades premium against the chance of having your shares called away:
- A higher strike pays less but leaves more room for the stock to rise before your gains are capped.
- A strike closer to the current price pays more, and is more likely to be exercised.
- A longer expiration pays more in total but ties up the shares longer; a shorter one pays less but gives you more frequent decisions.
- Higher IV means bigger premiums, because the market expects bigger moves, including moves through your strike.
Many people look at delta when choosing a strike. In the example, the $105 call has a delta of about 0.31, and the model puts the chance of it finishing in the money at about 28%. Neither number is a forecast; both come from today’s IV and change as the stock moves.
Reading the numbers on Wenlo
The options calculator prices one option at a time, so it shows the call on its own: the premium, its Greeks and the chance it finishes in the money. Keep in mind that the shares are a separate part of the position. Counting both, the model’s probability of profit for the example is about 58%: the chance the position makes at least $0.01 at expiration, which means the stock finishing above the $98.34 breakeven.
The calculator’s theta shows how much the sold call gains from one calendar day passing if nothing else changes, about $5.41 a day for the contract in the example. That decay is the reason the trade can earn money when the stock sits still. It is easily outweighed by a move in the stock.
To see how this fits with selling puts, read Cash-secured puts, explained and The wheel strategy, explained.