What Is a Covered Call? How It Works, With a Worked Example

You own some shares. They've been going sideways for a couple of months, they pay you nothing while they do it, and you'd be perfectly happy to sell them if they went up a bit. Somewhere out there is a person who'd like the right to buy them off you at a higher price, and they'll pay you for that right today.

That trade is a covered call, and it's the most common options position that ordinary shareholders actually put on.

We'll do the whole thing with one set of numbers, from the fee you're paid to the money you give up when the stock runs.

What a covered call actually is

There are two pieces, and you already have one of them.

The first piece is the stock. You own at least 100 shares of it, bought at some point, sitting in your account right now. Options contracts come in units of 100 shares, so 100 is the minimum — 100 shares gets you one contract, 300 shares gets you three.

The second piece is the call you sell. A call is a contract that gives its holder the right to buy 100 shares at a fixed price on or before a fixed date. You're on the other side of it: you're the one who has to hand over the shares if they ask.

That handover has a name: assignment. You're not matched to one particular buyer — when someone exercises, the OCC picks a clearing firm at random, the firm picks one of its customers, and the notice turns up in your account the next morning. You find out after it's happened.

For taking on that obligation you're paid a fee up front, called the premium, and the premium is yours the moment the trade goes through. It doesn't come back.

What you've sold, plainly, is the rise above the strike price. Below the strike nobody has any reason to exercise and the contract expires; above it your shares get bought at the strike. Our guide to options contracts covers that payoff shape in full if it's new.

Now the word "covered". It refers to those 100 shares sitting in your account. If you're assigned, you hand over stock you already own — you don't have to go into the market and buy it at whatever price the market is asking that day.

That's the whole distinction. Sell the same call without the shares behind it and you're short a contract you can't deliver on, which is the one options position whose loss has no ceiling — our guide to options contracts explains why, and it's not what this article is about.

Covered means the shares are already yours. It's the difference between promising to deliver something you have and promising to deliver something you'd have to go and buy.

A worked example

You own 100 shares of a stock you bought at $50. That's $5,000 of your money in the position, and it's trading at $50 today.

You sell one call at a $52.50 strike, 30 days out. Priced at 30% implied volatility on a standard options model, that call is worth $0.83 a share. One contract covers 100 shares, so $83 lands in your account today.

Here's what you've agreed to. For the next 30 days, if the stock gets above $52.50, your 100 shares can be called away at $52.50 each. Under $52.50 nobody exercises, and the contract expires. Either way the $83 stays with you.

The $83 also moves where you break even. Your shares cost $50 each, but you've now been paid $0.83 of that back, so the position is flat at $49.17 rather than $50.

The three ways it ends

Thirty days later the stock is somewhere. There are only three somewheres that matter: below your strike, between where it started and your strike, or above your strike.

It falls to $47. The call is worthless — nobody pays $52.50 for a $47 stock — so it expires and you keep the shares. Your stock is down $300 and you were paid $83, so you're out $217 instead of $300. That's better, and it is the entire extent of the help: the premium didn't stop the fall or slow it down, it just made the number $83 smaller. You still own the shares, and in 30 days you can sell another call against them.

It drifts to $51. This is the ending the strategy is built for. The stock rose but not past $52.50, so nothing gets called away and you're still holding your 100 shares — now worth $5,100 — with $83 on top. That's $183 against the $100 a plain shareholder made. You got the whole rise and the fee as well, because the stock stopped short of the line you drew.

It runs to $56. Your shares are sold at $52.50 — that's what you agreed to — so the position pays $5,250 plus the $83, and you're up $333. Look at that number for a second, because it's two things at once. It's the biggest of the three outcomes. It's also the largest amount this position can ever produce. The stock could have finished at $60, or $80, or $200, and you'd still have made $333, because everything above $52.50 went to the call holder.

Meanwhile the shareholder who did nothing made $600. So the awkward fact about a covered call is that its worst ending, judged against the alternative, is the one where the stock did best. You didn't lose money. You made your maximum and then watched from outside. If you liked the company enough to own it, being taken out of it in the month it finally moved is a real cost, and it tends to sting more than the $83 felt good.

One thing the three endings leave out: you don't have to wait. The call is a contract that trades, so you can buy it back and close the position any day you like — though the shares have to stay put until you do, because they're what makes it covered. If the stock has run, buying it back costs more than the $83 you were paid — so keeping the shares means handing back the fee and some. That's the same cap, paid in cash instead of in stock.

Where the covered call stops winning

It's worth moving the numbers around yourself. Drag the strike and the premium below and watch both lines redraw, along with the read-out that matters most — what the position is doing against simply holding the shares.

The covered call doesn't fall behind a plain shareholding at the strike. Below $52.50 the two are the identical trade except that you've been paid $83, so you're $83 ahead the whole way. At the strike you're still $83 ahead. The shares have to climb another $0.83 a share — the $83 premium spread over the 100 shares — before the plain shareholder catches up, and that happens at $53.33. Strike plus premium. Under that price you're in front; over it you're behind, and the gap widens for as long as the stock keeps going.

Choosing the strike

The strike is the one real decision here, and it's a straight trade between money now and room to run. Same stock at $50, same 30 days, four different strikes:

The $50 strike pays $180, more than double the $52.50 one. It also means you've agreed to sell at the price the stock is at right now, so you've sold every cent of upside for that $180. Go the other way and the $57.50 strike leaves you 15% of room to run, but it pays $11 — for most people that's not worth the commission and the month of attention.

There's no clever answer in that table. The strike that pays well is the strike you're most likely to get called away at. Those are one fact, not two.

Time works the same way. A call further out pays more than a 30-day one, because there's more time for the stock to reach the strike. That extra value drains away as expiry gets closer. The drain is called theta, and our guide to the Greeks covers it properly.

What it costs you

Four costs, and only the first one gets mentioned in most pitches.

The upside you sold

At $56, the cap cost $267. That's not a loss — you still made $333 — but it's $267 that the shareholder next to you kept and you didn't, on the same shares, in the same month. And you can't know in advance which month is the one where the stock runs. If you could, you wouldn't be selling calls against it.

The downside is still all yours

Look at the $47 row again. The premium softened a $300 fall by $83 and then did nothing else. Push it further: at $40 you'd be down $1,000 and holding $83. At $30, down $2,000 and holding $83. The fee is fixed and the fall isn't.

So a covered call is not a hedge, and it shouldn't be described as one. It's an income trade laid on top of a stock position whose risk you're keeping in full. The only thing standing between you and a bad quarter is the same thing that was there before you sold the call: the shares.

The 20%-a-year pitch

$83 on a $5,000 position is 1.66% for 30 days, and 1.66% twelve times is roughly 20% a year. That arithmetic is correct, and it's the number the covered-call pitch leans on. What's wrong with it is that the twelve months aren't twelve independent trials. The month the stock runs, your shares leave at the strike and there's no position left to write against — you either buy them back higher or you're out. The month it drops 15% is also in that average, and the premium covers roughly a ninth of it. The premium is what you collect, not what you earn.

Assignment around a dividend

American-style equity options can be exercised on any trading day, not just at expiry — and on a covered call there's one occasion where it regularly happens. Say the call is in the money — the stock is above the strike — and it's about to go ex-dividend. The holder has a reason to exercise early: buy the shares now, and the dividend is theirs. That only pays if the dividend is worth more than the time value left in the call, which is why it's the deep in-the-money ones that go.

The Options Industry Council puts it plainly — as the ex-date approaches, in-the-money calls become more likely to be exercised, and the writer may not even be notified until after the ex-date has passed. If that's you, your shares are gone at the strike and the dividend you were expecting went with them. So check the ex-dividend date before you sell a call whose life covers it — our guide to dividends explains how that date decides who gets paid. (This is a different situation from early assignment inside a vertical spread, where the leg you bought caps the damage; our spreads guide handles that one.)

When it makes sense

The test isn't whether the premium looks good. It's whether you'd be content to sell the shares at the strike, because that is the thing you're agreeing to.

It fits when:

• You already own at least 100 shares and would genuinely be happy to sell them at the strike you picked.
• You think the stock drifts sideways or up a little over the next month — the ending where a covered call beats holding.
• The holding pays you little or nothing, and you'd like it to pay something.
• You're prepared to keep holding it through a fall, because the premium won't stop one.

It doesn't fit when:

• You'd be upset to lose the shares — a long-term holding, a position with a big unrealised gain you don't want to trigger tax on, or something you own out of conviction.
• You think it might actually run. Earnings, a product launch, a takeover rumour: the month you most want to be a shareholder is the month a covered call pays least.
• You own fewer than 100 shares. One contract is 100 shares, and below that there's nothing to cover the call with.
• You bought the stock for its dividend and the ex-date falls inside the option's life.
• You're using the premium as a reason to keep holding something you'd otherwise have sold. That's not income, it's a rationalisation with a number attached.