What Is a Covered Call & How Do I Trade It?

If you're new to options trading or looking to enhance your stock positions, a covered call is one of the most beginner-friendly strategies to explore.

This approach allows you to generate income, reduce your cost basis, and increase your probability of profit—all while maintaining a bullish outlook on your stock.

In this guide, we’ll break down what a covered call is, how it works, and why it’s a powerful tool for investors. This post is brought to you by IncomeNavigator.com, your go-to resource for mastering income-generating strategies.

What Is a Covered Call?

A covered call is an options strategy where you own 100 shares of a stock and sell a call option against those shares.

The term "covered" refers to the fact that you already own the underlying stock, which mitigates the risk of the short call.

This strategy is ideal for beginners transitioning from stock investing to options or for seasoned traders looking to enhance returns.

Key points:

• Same risk profile as a short put: Both strategies have a bullish assumption, collect a premium, and reduce your cost basis.

• Bullish strategy: You benefit if the stock rises, stays flat, or even dips slightly.

How Does a Covered Call Work?

Let’s walk through an example to illustrate:

1. Buy 100 Shares: Suppose you purchase 100 shares of a stock trading at $100 per share. Your total cost is $10,000, which is your cost basis and also your maximum loss if the stock goes to zero (though stocks rarely drop to zero).

2. Sell a Call Option: You sell an out-of-the-money (OTM) call option, say at a $115 strike price, for a premium of $2 per share ($200 total, as each contract represents 100 shares). This premium immediately reduces your cost basis to $9,800 ($10,000 - $200).

3. Outcomes at Expiration:

   • Stock stays at $100: The call expires worthless, and you keep the $200 premium, effectively lowering your cost basis. You can sell the shares for $10,000, pocketing a $200 profit.

   • Stock rises to $115 or above: Your maximum profit is capped at $1,700. This is calculated as the $1,500 gain from the stock ($115 - $100 x 100 shares) plus the $200 premium. If the stock skyrockets to $200, your profit remains $1,700 because the call buyer exercises the option, buying your shares at $115.

   • Stock drops to $99: You still profit $100 because your cost basis is $9,800, and the shares are worth $9,900.

   • Stock drops below $98: You’d incur a loss, but the $200 premium cushions the blow compared to owning the stock alone.

Why Trade Covered Calls?

Covered calls offer several advantages that make them appealing for income-focused investors:

1. Cost Basis Reduction: Selling the call generates a premium, which lowers the net cost of your stock position.

2. This increases your probability of profit (POP), as the stock doesn’t need to rise for you to make money—it can stay flat or even decline slightly.

3. Bullish Flexibility: Covered calls maintain a bullish outlook but provide multiple ways to win:

   • The stock rises (up to the strike price).

   • The stock stays flat.

   • The stock dips slightly but remains above your reduced cost basis.

4. Income Generation: The premium from selling the call is yours to keep, regardless of the stock’s movement, as long as the option expires out-of-the-money.

5. Adjustable Strategy: You can sell calls at different strike prices to balance risk and reward:

   • Out-of-the-money (OTM): Higher strike prices (e.g., $115) offer more upside potential but lower premiums.

   • At-the-money (ATM): Closer to the stock’s current price (e.g., $105), these provide higher premiums but cap upside potential sooner.

For example, selling an ATM call at $105 for $5 per share reduces your cost basis to $9,500.

Your maximum profit drops to $1,000 ($500 stock gain + $500 premium), but you gain more downside protection, breaking even if the stock falls to $95.

Strategic Considerations

• Market Outlook: Covered calls work best when you’re bullish or neutral on a stock. If you expect a sharp decline, selling the stock outright may be better.

• Strike Selection: Choose a strike based on your goals. OTM strikes preserve more upside potential, while ATM strikes maximize premium and downside protection.

• Timing: If your stock is at an all-time high, selling an ATM call can lock in profits and reduce risk if you anticipate a pullback.

• Trade-Offs: Higher premiums come with lower maximum profit potential. Adjust your strike based on the stock’s recent performance and your risk tolerance.

Key Takeaways

• Reduced Cost Basis, Higher POP: Selling a call against your shares lowers your cost basis, increasing your probability of profit compared to owning stock alone.

• Flexible Adjustments: Adjust strike prices based on your market outlook—OTM for more upside, ATM for more premium.

• Profit Without Movement: Covered calls can be profitable even if the stock stays flat or drops slightly, thanks to the premium.

• Beginner-Friendly: This strategy is a great entry point for options trading, building on traditional stock investing.

Get Started with Covered Calls

Covered calls are a powerful tool for generating income and managing risk, making them a staple for income-focused investors.

At IncomeNavigator.com, we’re dedicated to helping you master strategies like these to build consistent returns.

If you have any questions, please email: [email protected]