Covered call

A covered call adds a written call to shares. When the call is written on shares that are already owned, the position is also called an overwrite, and when the shares are bought at the same time, a buy-write. The shares cover the obligation of the call: if the call is assigned, they are what is delivered.

What a covered call is

The writer owns 100 shares and sells one call on them. The premium is received at once and kept in every case.

In exchange the writer is obliged to sell the 100 shares at the strike price if the call is assigned. Above the strike price the writer has sold the rise of the stock to the holder of the call. Below it the writer owns the shares as before, with all their risk.

How a covered call makes and loses money

The position is shares plus a written call, and its result at expiration is the sum of both.

• The stock is above the strike price. The shares are called away at the strike price. The result is the strike price less the cost of the shares, plus the premium. It is the maximum gain and it does not grow when the stock rises further.
• The stock is at or below the strike price. The call expires worthless. The writer keeps the shares and the premium, and the result is the gain or loss of the shares plus the premium.

• 100 shares alone
• Covered call

Profit or loss at expiration

Stock price at expiration	100 shares alone, per share	100 shares alone, per contract	Covered call, per share	Covered call, per contract
$35	-$15	-$1,500	-$14	-$1,400
$49	-$1	-$100	$0	$0
$50	$0	$0	+$1	+$100
$55	+$5	+$500	+$6	+$600
$65	+$15	+$1,500	+$6	+$600

The break-even at expiration is the cost of the shares less the premium.

Example of a covered call

What happens to a covered call before expiration

The written call loses value as time passes, which works for the writer, and gains value when the stock rises or when implied volatility rises, which works against the writer.

When the stock rises toward the strike price, the shares gain more than the call costs, so the position as a whole gains, more and more slowly. When the stock falls, the call loses value and softens the loss of the shares a little. The position always gains less than the shares on the way up and loses almost as much on the way down.

What happens when a covered call is assigned

On assignment the 100 shares are delivered and the writer receives the strike price times 100. The position is over. The sale of the shares is a sale like any other, with a gain or a loss against what they cost.

A call can be assigned before its expiration. It happens most often on the day before the stock goes ex-dividend, when the call is in the money and the dividend is larger than the time value the call has left. The writer then delivers the shares and does not receive the dividend.

How a covered call position is managed

The shares cannot be sold while the call is open without leaving an uncovered call behind. A writer who wants to sell the shares closes the call first.

What can go wrong with a covered call

The risk of loss comes from holding the stock, and the call does not add to it. It also takes little of it away. A premium of $1.00 covers the first dollar of a fall. If the stock falls from $50 to $30, the position has lost $1,900 per 100 shares.

The gain is capped for the life of the call. A stock that rises 30% in a month pays the writer the maximum gain, $600 in the example, and the rest of the rise goes to the holder of the call. Over many months a writer keeps the small gains, gives up the large ones and keeps the large losses.

Writing calls with a strike price below the cost of the shares can lock in a loss. If shares bought at $50 trade at $42 and a call with a strike price of $45 is written for $1.00 and assigned, the shares are sold at $45 and the result is ($45 - $50 + $1.00) × 100 = -$400.