What is a covered call?

Selling a call against shares of long stock is called a covered call. When you sell a covered call, you receive money right away (the "credit"). Usually, you sell a call that is out-of-the-money (meaning the strike price is higher than the current price of the underlying asset). If the stock price goes up, the buyer of the call will want to buy your stock at the higher price. This is called being "in-the-money." If this happens, you will have to sell your stock at a higher price.

When you sell a covered call, you are still at risk if the price of the stock drops. However, selling a covered call does add credit to your account. This reduces the overall cost of holding the stock.

You can execute the strategy with put and call options of any expiration date and strike price, but the call and put sides must have the same expiration date. They must also correspond to the same number of contracts.

When executing this trade, it is important to be mindful that the price of a put option with a strike price that is equidistant from the stock as a call option will typically be more expensive. So if you want to enter a costless collar position, you generally need to enter the trade when there is a slight skew in strike prices relative to the underlying stock. This means that the strike price of the call option will be closer to the underlying stock than the strike price of the put option.

When to use a covered call strategy

Covered calls work best when the price of the stock increases modestly and volatility decreases. This means that as a trader, you are feeling neutral to bullish on a stock you own, but you are willing to sell it if it reaches a certain price.

How to manage a covered call position

This strategy uses time decay to your advantage. As time goes by, you want to see the call option lose value and approach zero. You want the implied volatility of the option you sold to decrease. This will make the option less expensive to close prior to expiration.

Covered call maximum profit potential

When you sell a call, you receive a premium. This is the amount of money you get for selling the call. When you sell a covered call, your maximum profit is limited to the strike price minus the current stock price plus the premium.

Covered call maximum loss potential

You receive a premium when you sell a covered call option, but you still face downside risk by owning the stock, which may potentially lose its value. Moreover, selling the option does create an “opportunity risk.” That is, if the stock price rises sharply, your call options might be assigned and you’ll miss out on those gains.