Covered calls can be a powerful way to earn extra income from stocks you already own. Like any strategy, they come with trade-offs. Before diving into how they work, it is important to review the basics of options.
Options come in two types: calls and puts. A call option gives the buyer the right, but not the obligation, to purchase a stock at a set price (the strike price) before it expires. Each contract typically covers 100 shares. If the stock price ends up above the strike price at expiration, the call is “in-the- money,” and exercising it can generate a profit equal to the difference between the market price and strike price. If the price is below the strike price, the call expires worthless or “out-of-the-money.”
Options can be bought or sold. Selling a call without owning the stock, known as a naked call, is extremely risky. If the stock soars past the strike price, the seller must deliver shares at a steep loss. Both buying calls and selling naked calls are speculative bets that only succeed if the investor correctly predicts the stock’s direction.
From the day an option is opened, until it expires, the stock price will move up and down. The greater the expected volatility, the harder it is to know if the option will finish in the money. This uncertainty is reflected in the option’s premium, which steadily declines as expiration approaches. All else equal, an option expiring in one month will lose value each day if the stock price stays the same. For more detailed information on how options are priced read The Greeks: From Past to Present.
Covered Calls in Action
A covered call combines stock ownership with selling a call option. Suppose XYZ stock trades at $52, and a one-month call with a $55 strike sells for $3. You could buy 100 shares of XYZ and sell that call. You would collect the $3 per share premium up front, but you would be obligated to sell at $55 if the buyer exercises the option. The trade generates income but limits your potential upside if the stock rises sharply.
Pros of Selling Covered Calls for Income
Immediate income. The seller collects the option premium upfront. In this example, that is $300. If the stock stays below $55 at expiration, the seller keeps both the 100 shares and the premium.
Defined profit potential. If the stock closes above $55 at expiration, the call is exercised and the shares are sold. The total profit is the $300 premium plus $300 in capital appreciation, for a total of $600.
Downside cushion. The premium can offset a moderate drop in the stock price. For example, if the stock falls from $52 to $49 and the shares are sold, the $3 loss per share is fully offset by the $3 premium, resulting in no net loss.
Cons of Selling Covered Calls for Income
Limited upside. Gains are capped at the premium received plus the difference between the purchase price and the strike price, even if the stock rises far above the strike.
Reduced flexibility. The shares cannot be sold without first buying back the call option. If the stock falls more than the premium amount, the trade results in a net loss.
Premium reflects volatility. Higher premiums usually mean the stock is more volatile, which increases the risk of large price swings.
Limited downside protection. Losses from a decline in the stock price are only reduced by the premium, which may be small relative to the potential drop in value.
Is Selling Covered Calls “Worth It”?
Selling covered calls can provide steady income from an equity portfolio, but it also comes with trade-offs, including limited upside potential and limited downside protection. An options-based income strategy can be as simple as selling covered calls or as sophisticated as incorporating strict rules and processes to manage income, emotion, and risk. If you are considering this approach, it is important to compare the risk–reward profiles of different strategies and choose one that aligns with your objectives, risk tolerance, time horizon, and temperament.
Covered calls are most effective when used as part of a comprehensive, rules-based strategy designed to balance income generation with risk management. The Snider Method, for example, incorporates covered calls into a disciplined process that helps investors manage their positions consistently and remove emotion from decision-making. This structured approach allows covered calls to work as one component of a broader, long-term income plan.