What is a covered call? How it works, with an example

Written by the Tactfolio research teamPublished 5 min read

A covered call is when you own 100 shares of a stock and sell someone the right to buy them at a set price. You get paid cash up front for that right. In return, you give up gains above that price until the option ends. Your shares still lose value if the stock falls.

Key points#

  • You need 100 shares for each call you sell. The shares “cover” the promise to sell.
  • The cash you collect is called the premium. You keep it no matter what happens.
  • If the stock rises above the strike price, your shares will likely be sold at that price.
  • The premium softens a fall a little. It does not stop one.
  • Covered call ETFs, such as QYLD, run this strategy for you inside a fund.

Risk note. Options can expire worthless. Selling options can lose far more than the premium you collect. With a covered call, the shares you own carry the main risk.

What is a covered call?#

A covered call has two parts. You own a stock. You sell a call option on that same stock.

A call option is the right to buy 100 shares at a set price, called the strike price, before a set date. When you sell the call, the buyer pays you a premium. If the buyer uses the option, you must sell your shares at the strike price. Because you already own the shares, you can always deliver them. That is what makes the call “covered”.

Selling a call without owning the shares is called a naked call. It has no limit on losses. A covered call does not have that problem.

A covered call example#

Say you own 100 shares of a stock at $50. Your shares are worth $5,000. You sell one call with a $55 strike that ends in 30 days. The buyer pays you $1 per share, or $100.

Here is what happens at the end of 30 days, compared with just holding the shares:

Stock price at the endJust holdingCovered callWhat happened
$45−$500−$400The call expires. You keep the $100.
$50$0+$100The call expires. You keep the $100.
$53+$300+$400The call expires. You keep the $100.
$55+$500+$600Your best case.
$60+$1,000+$600Your shares are sold at $55.

The pattern is clear. The covered call does better when the stock is flat, a bit up or down. It does worse when the stock jumps. Your best result is capped at the strike price plus the premium.

Why do people sell covered calls?#

Most people sell covered calls to earn cash from shares they already own. The premium is paid right away.

Some also use it as a planned exit. If you would happily sell a stock at $55, a $55 covered call pays you to wait for that price.

What are the risks of a covered call?#

The biggest risk is the stock falling. The premium only covers the first small part of a drop. A gap down after bad earnings can take the price far below where you started. If the stock falls 30%, you still lose most of that 30%.

The second risk is missing a big rise. If the stock doubles, your shares are sold at the strike price. You keep only the premium and the gain up to the strike.

Other points to know:

  • Taxes. Premiums and sold shares can create taxable gains. Rules for options can be tricky, so ask a tax professional. Inside a retirement account, such as an IRA, the rules are different.
  • Early assignment. US stock options can be used any day before they end. You may have to sell your shares early, often just before a dividend.
  • Fees and approval. Your broker must approve your account for options trading (FINRA).

Covered call ETFs#

A covered call ETF is a fund that owns stocks and sells calls on them for you. It pays much of the premium out to holders, often monthly. You need only one share, not 100.

One example is the Global X Nasdaq 100 Covered Call ETF (QYLD). It owns the Nasdaq-100 stocks and sells calls on that index each month (Global X). Others use different methods. Read each fund’s own page before you buy.

These funds have the same trade-off as a single covered call. They tend to trail their stock index in strong markets, because they give up the big gains. Cboe tracks a simple version of this strategy on the S&P 500 with its BuyWrite Index (BXM).

Common mistakes#

  • Selling a call on a stock you are not willing to sell at the strike price.
  • Choosing a strike just because its premium is high. A high premium often means the stock is expected to swing a lot.
  • Thinking the premium is “free money”. You are trading away upside to get it.
  • Forgetting that the shares can still fall a lot.
  • Looking only at a fund’s payout rate. A high payout can come with a falling share price.

Try it on Tactfolio#

Tactfolio does not trade options. But covered call ETFs trade like any other fund, so you can test one inside a rules-based strategy. In the strategy builder, add a fund such as QYLD next to the S&P 500 and compare their hypothetical backtests, drawdowns included. To see how options lose value over time, read what theta means.

Common questions#

Is a covered call a good strategy?#

It suits someone who owns a stock, expects it to stay flat or rise slowly, and is happy to sell at the strike. It does poorly when the stock jumps or falls a lot. It changes your risk and return. It does not remove risk.

Can you lose money on a covered call?#

Yes. If the stock falls by more than the premium you collected, you lose money. The loss comes from the shares you own, not from the call itself.

What happens if my covered call gets exercised?#

Your broker sells your 100 shares at the strike price. You keep the premium too. Your total gain is the strike price minus what you paid for the shares, plus the premium.

Do covered calls pay every month?#

They can. Many sellers pick calls that end in about a month and sell a new one each time. Covered call ETFs often pay out monthly. The amount changes with market conditions and is not fixed.

What is the difference between a covered call and a naked call?#

With a covered call, you own the shares, so you can always deliver them. With a naked call, you don’t. If the stock soars, a naked call seller must buy shares at the high price, which can mean very large losses.

Sources

Put it into practice