Definition · Options
Covered Call: Definition, Payoff, Breakeven and Risks
A covered call trades away the stock's upside above one price for cash today. Before you sell, know the most you can make, the breakeven and what is left when the stock falls.
DefinitionSeen on: Option chain
Covered call Owning 100 shares of a stock and selling one call option against them, collecting the premium in exchange for giving up any gain above the call's strike price.
Also called buy-write, covered call writing, overwriting.
Sell to open, 1 contract, the 32 call, limit $0.75. The shares are already in the account: 100 of them, bought at $30. The order fills. Now $75 sits in cash, and you’ve agreed to sell the shares at $32 if the buyer wants them. Everything about the trade follows from that one ticket.
Maximum profit, breakeven and the loss on a fall
The maximum is fixed on the day you sell. The stock can go to $32 or to $50 and the result is the same $275, because above the strike the call you sold gains what the shares gain.
The breakeven is the purchase price less the premium. Below it you lose. The shares carry the whole downside, and the premium is a fixed cushion that doesn’t grow as the stock falls, so a drop from $30 to $27 costs $300 on the stock with $75 of it recovered, and a drop to $20 costs $1,000 with the same $75 recovered. The covered call calculator runs the same sums for your own strike and premium.
Assignment
The call’s buyer can exercise it. Your shares are then sold at the strike. Assignment usually comes at expiration, when the stock finishes above the strike. Early assignment happens too. It is most likely just before an ex-dividend date, because a call holder who exercises the day before gets the shares in time to collect the dividend, and when the dividend is worth more than the time value left in the call, that is the rational move.
If you’d rather keep the shares, you can close the call before it’s exercised by buying it back, and many traders then sell a new call at a later expiration or a higher strike, a move called rolling. Rolling costs whatever the old call is worth at the time. On a stock that has run well past the strike, that buyback can wipe out the premium you collected and more.
Where it shows on the option chain
On the chain, find the expiration you want and the call side. Each strike shows a bid and an ask. When you sell, the bid is what a buyer is paying right now, so a covered call priced at the bid should fill; a limit between the bid and the ask may fill or may sit. In the example, $0.75 is the bid on the 32 call. The ask is what you’d pay to buy that call back, which is the number that matters if you later want to close the position and keep your shares.
The chain also shows how far out of the money each strike is. A strike close to the current price pays more premium and leaves less room for the stock to rise before the cap bites, while a strike far above it pays little and caps you only after a large move, and the right choice depends on whether you care more about the income or about keeping the shares.
What people get wrong
The biggest error is treating the premium as protection. It covers $0.75 a share. After that, a covered call on a stock that falls hard loses almost as much as the stock does, less a small rebate.
The second error is forgetting that the cap is real. If the stock jumps to $40 on news, the position still makes $275, and watching the shares leave at $32 is part of the deal you signed.
A third is taxes. Selling calls on shares with a large unrealized gain in a taxable account means that if the shares are called away, the gain is realized and taxed in that year. Check how your holding period and cost basis would be treated first.
The approach gets its full treatment in covered calls on dividend stocks, and the wheel strategy shows how covered calls pair with selling puts.
Related terms
A buy-write is buying the shares and selling the call in one order. The strike is the price you agree to sell at. Assignment is the notice that the call has been exercised against you. The call’s delta is a rough gauge of assignment odds. More on options sits under the options desk.
Questions traders ask next
Can you lose money on a covered call?
Yes. The premium only offsets the first part of a fall in the shares. If the stock drops below your purchase price minus the premium, you are losing money, and the loss grows with every dollar the stock falls from there, just as it would if you owned the shares with no call.
What happens if the stock is above the strike at expiration?
The call is normally exercised and your 100 shares are sold at the strike price. You keep the premium and the gain up to the strike, and give up anything above it. If you want to keep the shares, you can buy the call back before expiration, at whatever it costs by then.
Should you sell a covered call on a stock you don't want to sell?
Only if you are ready for the shares to go. Every covered call carries the chance of assignment at the strike. If parting with the stock at that price would bother you, pick a strike you would be glad to sell at or skip the trade.