Covered Calls Explained: How the Strategy Works, Profits, Risks, and Examples

Introduction / Definition

A covered call is an options trading strategy where an investor sells (writes) call options on a stock they already own. The investor collects an option premium in exchange for giving another investor the right to buy the shares at a predetermined price (the strike price) on or before the option’s expiration date.

The strategy is considered “covered” because the shares are already owned and can be delivered if the option is exercised. Selling a call without owning the shares is known as a “naked call,” which carries higher risk because shares may need to be purchased at unfavorable prices.

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Key Takeaways

• Covered calls generate income from option premiums when the investor expects the stock to stay stable or rise slightly.
• The strategy combines a long stock position with selling a call option on the same stock.
• Upside is limited because shares may be sold at the strike price if exercised.
• The premium can reduce the effective cost basis, offering some cushion against minor declines.
• The strategy still carries downside risk if the stock price falls significantly.

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How a Covered Call Works

What the option buyer receives

A call option gives the buyer the right, but not the obligation, to buy shares of the underlying stock at the strike price any time before the option expires.

What the option seller gives up

When writing a covered call, the stockholder sells that right to another investor in exchange for a cash premium. If the buyer exercises the option, the call writer must sell the shares at the strike price.

Because the call writer already owns the shares, the position is “covered.” This avoids the core problem of a naked call, where the seller might need to buy the stock at a higher market price to deliver shares.

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How Covered Calls Can Generate Profit

The premium is retained regardless

When a call option is sold, the premium received is kept whether the option is exercised or not.

The most favorable outcome for premium collection

A covered call is typically most profitable when the stock price stays below the strike price through expiration. In that case, the option can expire worthless and the investor keeps both the shares and the premium.

What happens if the stock rises above the strike

If the stock rises above the strike price and the option is exercised, the investor must sell shares at the strike. This limits upside beyond the strike, but the investor still participates in gains up to the strike price and keeps the premium.

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When Selling a Covered Call May Fit

Covered calls can be used when an investor expects the stock to remain relatively stable or rise modestly and is willing to sell shares at a specific price.

Illustrative example from the source:

• Stock purchased at $80 per share
• Investor expects it might rise to $90 within a year
• Investor is willing to sell at $85 within six months
• Selling an $85 six-month call earns a $5 premium per share

Outcomes described in the source:

• If shares are called away at $85, the investor receives $85 from the sale plus the $5 premium, totaling $90 per share, which equals a $10 gain on an $80 cost basis (12.5% over six months).
• If the stock drops to $70, the option is not exercised. The stock loss is $10 per share, but the $5 premium reduces the net loss to $5 per share.

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Example Scenarios

Bullish scenario: shares rise and the option is exercised

• January 1: Buy ABC shares at $90
• January 1: Sell ABC call option for $6, expires June 30, exercisable at $100
• June 30: Stock closes at $110, option is exercised, shares are sold at $100
• July 1: Profit = $10 capital gain ($100 − $90) + $6 premium = $16 per share ($16 ÷ $90 = 17.8%)

Bearish scenario: shares drop and the option is not exercised

• January 1: Buy ABC shares at $90
• January 1: Sell ABC call option for $6, expires June 30, exercisable at $100
• June 30: Stock closes at $75, option expires worthless
• July 1: Loss = $15 share loss ($90 − $75) − $6 premium = $9 per share ($9 ÷ $90 = 10% loss)

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Advantages and Risks of Covered Calls

Advantages

Covered calls can enhance portfolio yield by generating premium income that can supplement dividends and potentially increase overall returns. The premium also lowers the effective cost basis, which can cushion the impact of minor price declines.

Covered calls are often described as most suited to environments where major stock appreciation is not expected, because upside beyond the strike price is capped.

Risks

Covered calls still have downside risk if the stock declines significantly. The premium may not fully offset losses below the breakeven point (purchase price minus premium).

There is also a practical constraint: because the shares may be called away, an investor who wants to keep the shares may need to buy back the option before expiration. This can increase transaction costs and affect net outcomes.

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Covered Call Variations Mentioned in the Source

The traditional covered call example (with breakeven)

• Buy 100 shares at $80 per share
• Sell a call option with a strike price of $80
• Collect a $4 premium ($400)
• Total stock cost: $8,000; premium received: $400
• Breakeven price: $76 per share ($80 − $4)

Outcomes described in the source:

• If the stock drops to $76, the stock loss ($400) is offset by the premium ($400) for breakeven.
• If the stock exceeds $80 at expiration, shares may be called away, which caps profit at $400 in this illustration.

“Directional covered call without the stock” (structure in the source)

The source describes an alternative that replaces stock ownership with a longer-dated call while selling shorter-dated calls, reducing capital requirements.

Example figures provided:

Standard covered call:

• Buy 100 shares at $120
• Sell one December 115 call at $12
• Net outlay shown in the source: $12,000 − $1,200 = $10,800
• Max profit shown in the source: $700 (6.5%)
  • (This aligns with the numbers: if shares are sold at $115, the stock loss is $5 per share, offset by the $12premium, netting $7 per share = $700.)

Directional covered call without the stock:

• Buy three January 110 calls at $8
• Sell two December 115 calls at $12
• The source lists a “Cost: $2,400” and “Max profit: $2,000 (83.3%).”
• Using the option prices provided, the gross cost of the long calls is $2,400 and the gross premium from selling calls is $2,400, meaning the net option premium is $0 before commissions and margin considerations. The example’s structure and profit figures are presented as given in the source.

“Trade the covered call—without owning the stock” (calendar spread example)

The source provides a comparison between a traditional buy/write and an all-options alternative.

Traditional buy/write:

• Stock trading at $60.50
• March 60 call priced at $7.50
• Buy 100 shares at $60.50 = $6,050
• Sell one March 60 call at $7.50 = $750 premium
• Breakeven price: $53.00 ($60.50 − $7.50)
• Maximum profit stated: $700, which matches the arithmetic if called at $60:
  • Per-share result: $60 + $7.50 − $60.50 = $7.00 → $700

All-options alternative (corrected arithmetic based on the stated option prices):

• Buy three June 55 calls at $9.20 each → $2,760
• Sell two March 60 calls at $7.50 each → $1,500 collected
• Net entry cost: $1,260 ($2,760 − $1,500)

Example result provided (with corrected arithmetic):
If the stock rises to $75 by March expiration:

• Sell three June 55 calls at $25 each → $7,500
• Buy back two March 60 calls at $20 each → $4,000
• Net proceeds: $3,500 ($7,500 − $4,000)
• Profit vs. net entry cost: $2,240 ($3,500 − $1,260)
• Return on net entry cost: 177.8% ($2,240 ÷ $1,260)

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Context or Application

Covered calls sit at the intersection of income generation and risk control. The premium can lower the effective cost basis, which can soften small declines. At the same time, the obligation to sell shares at the strike price means the strategy trades away open-ended upside in exchange for upfront premium income.

This trade-off is why the strategy is often described as conservative: it does not remove downside risk, but it can reshape outcomes when prices are flat, slightly higher, or slightly lower over the option’s timeframe.

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Conclusion

A covered call combines long stock ownership with selling a call option to collect premium income. The premium is retained regardless of exercise, but the strategy limits upside if the stock rises above the strike price. While covered calls can reduce cost basis and generate income, they still expose the investor to losses if the stock declines significantly.

Understanding the mechanics, the exercise obligation, and the payoff trade-offs is central to using covered calls effectively as an options strategy.

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FAQs

What is a covered call?

A covered call is an options strategy where an investor sells call options on a stock they already own in exchange for a premium.

Why is it called “covered”?

It is called “covered” because the investor owns the underlying shares and can deliver them if the call option is exercised.

When does a covered call tend to be most profitable?

A covered call tends to be most profitable when the stock stays below the strike price through expiration so the premium can be kept and the shares are not called away.

What happens if the stock price rises above the strike price?

If the stock price rises above the strike price and the option is exercised, the investor must sell the shares at the strike price, which limits upside beyond that level.

How does the premium affect downside risk?

The premium lowers the investor’s effective cost basis, which can reduce losses from minor price declines, but it may not offset large declines in the stock.

What is the main risk of a covered call?

The main risks are capped upside if the stock rises sharply and continued downside exposure if the stock price falls significantly.

This article was created with AI assistance and reviewed by an editor. For more information, please refer to our Terms of Use.

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Risk Disclosure

All content is provided for educational purposes only and does not constitute investment advice. Trading involves risk, and past performance is not indicative of future results. Please review our full Risk Disclosure for additional details.

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