When to Use Covered Call Options
When to Use Covered Call Options

An option trading strategy that is often used by long term investors is the covered call option. This strategy involves selling calls on a stock that you already own. The goal is to keep the stock and make a profit on the premium paid for the call option that you sell. The worst-case scenario with a covered call option is that the stock rises significantly in price, and you end up selling it for the contract strike price which is lower than the new market price. When to use covered call options is when you believe the stock price will not go up. An alternative approach is to buy the stock and then sell a call option. This is called a “buy-write” transaction.

Calls Versus Covered Calls

A call contract gives the buyer the right to purchase a stock at a fixed price called the strike price. The buyer of the contract will only make a purchase if the stock price goes up and thus makes the transaction profitable. The ability to make the purchase lasts until the contract expires. Thus the buyer believes the price of the stock will go up and the seller believes that it will not. The price only needs to stay flat for the seller of the contract to make a profit. If an options trader simply sells a call without owning the stock, they can still make money but, if the stock goes up significantly, they will need to purchase the stock at the now-higher market price in order to sell it immediately at the lower strike price. This will reverse any potential profit. Owning the stock in question is insurance that the seller will not have to come out of pocket if they need to sell the stock.

When to Use a Covered Call

An advantage that a stock owner has is that they are familiar with the stock in question and have followed its ups and downs, sometimes for years. As such, they frequently can predict more accurately than the buyer that the stock is trading at its upper limit and will move lower or simply trade sideways despite expectations or hopes on the part of the buyer than a rally is in the offing. Investors who successfully use this approach are adding a “dividend” from time to time on top of any actual dividends paid by the stock. Both technical analysis and analysis of fundamentals are useful in helping predict where the stock in question is going to trade during the term of an option contract. A fact in options trading is that sellers generally make more money than buyers of both calls and puts. The risk of only selling calls is that from time to time a dramatic market movement upward will erase months of profits in an afternoon. When the person owns the stock in question, they may lose out on a rally but will not lose money in the trade.

Potential Losses in a Covered Call

While the use of a covered call approach promises short term profits without the risk of huge losses out of pocket there can still be losses or expenses. One is that the investors can lose out on the stock appreciation they would have experienced if the stock rallies and they have to sell it for a lower-than-desired price. Another issue is that if the person owned the stock for years, they may need to pay capital gains tax on the profit from when they first bought the shares until when they sold. They may have sold the stock eventually anyway but perhaps did not expect to have to pay capital gains tax at the current point in time. If you are trading a covered call on a stock that you hold in an IRA, traditional or Roth, any tax consequences will not be immediate.

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