Covered Calls Explained: How to Generate Income from Stocks You Own

You own stocks. They sit in your portfolio. Some pay dividends, some don't. But there's another way to generate income from stocks you already own: selling covered calls.

Covered calls let you collect premium income by selling someone the right to buy your shares at a higher price. If the stock stays below that price, you keep the premium and your shares. If it rises above, you sell at a profit — just not as much as you might have made.

This guide explains how covered calls work, when they make sense, and how to implement this strategy effectively.

What Is a Covered Call?

A covered call combines two positions:

1. Long stock — You own 100 shares (or multiples of 100)
2. Short call — You sell a call option against those shares

The "covered" part: Your obligation to potentially sell shares is "covered" by the shares you already own. This is different from a "naked" call, where you'd sell calls without owning the stock (much riskier).

The Basic Mechanics

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You own: 100 shares of XYZ at $50 ($5,000 position)
You sell: 1 XYZ call option, $55 strike, 30 days out
You receive: $1.50 premium ($150 total)

Three possible outcomes at expiration:

Why Sell Covered Calls?

The Benefits

1. Generate income

• Collect premium on stocks you own
• Income regardless of whether stock moves
• Can enhance yield significantly

2. Lower cost basis

• Premium received reduces your effective purchase price
• Provides small buffer against losses

3. Defined outcome

• Know your maximum profit upfront
• Know the price you'll sell at if assigned

4. Works in flat markets

• Profit even when stock goes nowhere
• Beat buy-and-hold in sideways markets

The Trade-offs

1. Capped upside

• If stock soars, you miss gains above strike
• Opportunity cost can be significant

2. Limited downside protection

• Premium only slightly offsets losses
• Still bear full risk of stock decline

3. Potential tax complexity

• Assignment triggers capital gains
• May not align with your tax planning

4. Obligation to sell

• May have to part with shares you wanted to keep
• Can be inconvenient timing

The Covered Call P&L Diagram

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Profit
  |
  |         _______________  <- Max profit (premium + stock gain to strike)
  |        /
  |       /
  |      /
  |_____/_____________________ Stock Price
  |    /   Breakeven
  |   /    (purchase price - premium)
  |  /
  | /
  |/
Loss

Key points:

• Maximum profit = Strike price - Stock purchase price + Premium received
• Breakeven = Stock purchase price - Premium received
• Maximum loss = Stock goes to $0 (minus premium received)

How to Set Up a Covered Call

Requirements

1. Own at least 100 shares of the underlying stock
2. Options-approved account with your broker
3. Understanding of assignment risk

Step-by-Step Process

Step 1: Select the underlying stock

• Should be a stock you're willing to hold
• Should be a stock you're willing to sell at the strike
• Adequate options liquidity (tight bid-ask spreads)

Step 2: Choose expiration date

• Shorter = faster time decay, more management
• Longer = higher premium, less flexibility
• Common choices: 30-45 days out

Step 3: Choose strike price

• Higher strike = less premium, less likely assigned
• Lower strike = more premium, more likely assigned
• Balance income vs. upside potential

Step 4: Sell the call

• "Sell to open" the call option
• Collect premium immediately
• Monitor position

Step 5: Manage at expiration

• If below strike: Option expires, sell another call
• If above strike: Shares get called away, or roll the option

Strike Price Selection

Choosing the right strike price is the most important decision.

Strike Price Strategies

Out-of-the-Money (OTM) Calls

• Strike above current stock price
• Lower premium, lower probability of assignment
• Allows more upside participation

At-the-Money (ATM) Calls

• Strike equal to current stock price
• Highest time value (premium)
• ~50% probability of assignment

In-the-Money (ITM) Calls

• Strike below current stock price
• Higher premium (includes intrinsic value)
• High probability of assignment
• More downside protection

The Delta Approach

Options delta indicates probability of finishing in-the-money:

Popular choice: 0.30 delta (30% chance of assignment, 70% chance of keeping shares)

Expiration Date Selection

Time until expiration affects premium and flexibility.

Time Decay (Theta)

Options lose value as expiration approaches. This decay accelerates in the final weeks.

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Time Value Decay:

|100%
|  \
|   \
|    \
|     \
|      \
|       \_____
|             \____
|                  \____
|_______________________\____ Expiration
90   60   45   30   14   7   0 days

Key insight: The final 30 days see the most rapid decay. Selling 30-45 day options captures this efficiently.

Expiration Strategies

Sweet spot: 30-45 days to expiration balances premium, time decay, and management effort.

Calculating Returns

Premium Yield

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Monthly Yield = Premium Received / Stock Price
Annualized Yield = Monthly Yield × 12

Example:

• Stock price: $50
• Premium received: $1.00
• Monthly yield: $1.00 / $50 = 2%
• Annualized: 2% × 12 = 24%

If Called (Maximum Return)

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If Called Return = (Strike - Stock Price + Premium) / Stock Price
Annualized = If Called Return × (365 / Days to Expiration)

Example:

• Stock price: $50
• Strike price: $52.50
• Premium: $1.00
• Days to expiration: 30

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If Called Return = ($52.50 - $50 + $1.00) / $50 = 7%
Annualized = 7% × (365/30) = 85% (theoretical)

Realistic Expectations

Note: High volatility premiums are attractive but signal higher risk of large moves.

Managing Covered Calls

Scenario 1: Stock Below Strike (Ideal)

What happens: Option expires worthless.

Action:

• Keep the premium ✓
• Keep your shares ✓
• Sell another call for the next period

Scenario 2: Stock Above Strike

Option A: Let shares be called away

• Shares sold at strike price
• Keep the premium
• Realize capital gain/loss
• Redeploy capital elsewhere

Option B: Roll the option

• Buy back current call (at a loss)
• Sell new call at higher strike and/or later expiration
• Collect net credit or pay small debit
• Keep your shares

Rolling example:

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Original: Sold $55 call for $1.50, stock now at $57
- Buy back $55 call for $2.50 (loss of $1.00)
- Sell $60 call next month for $2.00 (new credit)
- Net: Pay $0.50, but keep shares and raise strike to $60

Scenario 3: Stock Drops Significantly

What happens: Option expires worthless, but shares lost value.

Action:

• Keep the premium (small consolation)
• Decide: hold shares or sell
• If holding, sell another call at lower strike
• Accept that premium only partially offset losses

When to Close Early

Consider closing before expiration if:

• Stock moved significantly (capture most of profit early)
• Better opportunity elsewhere
• Earnings or dividend approaching
• Option has minimal value left (why wait for pennies?)

Rule of thumb: Close when you've captured 50-75% of maximum profit.

The Wheel Strategy

A popular covered call extension that creates a cycle of income.

How It Works

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Step 1: Sell cash-secured put
        ↓ (if assigned)
Step 2: Own shares, sell covered calls
        ↓ (if called away)
Step 3: Back to selling puts
        (repeat)

Step 1: Sell put on stock you want to own

• Collect premium
• If stock drops, buy at strike (lower than current)
• If stock stays up, keep premium, repeat

Step 2: When assigned shares, sell covered calls

• Collect premium
• If stock rises, sell at strike (profit)
• If stock stays flat, keep premium, repeat

Benefit: Generate income whether you own shares or not.

Covered Calls and Dividends

Ex-Dividend Risk

Call holders may exercise early to capture dividends.

When this happens:

• Stock approaches ex-dividend date
• Call is in-the-money
• Dividend exceeds remaining time value

Example:

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Stock: $52
Strike: $50 (ITM)
Call value: $2.50 ($2 intrinsic + $0.50 time value)
Upcoming dividend: $0.75

If exercised: Call holder pays $50, gets $52 stock + $0.75 dividend
If not exercised: Call worth $2.50

Exercise makes sense: $52 + $0.75 - $50 = $2.75 > $2.50

How to handle:

• Avoid selling ITM calls near ex-dividend dates
• Be prepared for early assignment
• Consider closing position before ex-date

Dividend Capture Consideration

If you want the dividend, ensure your call isn't exercised before ex-date by selling OTM calls with time value exceeding the dividend.

Best Stocks for Covered Calls

Ideal Characteristics

Good Candidates

• Large-cap stocks with liquid options
• Dividend aristocrats
• Stable sectors (utilities, staples, healthcare)
• ETFs (SPY, QQQ, IWM)

Avoid

• Pre-earnings positions (unless intentional)
• Biotech with FDA decisions
• Penny stocks (no options or illiquid)
• Stocks you don't want to own
• Merger/acquisition targets

Covered Call Mistakes to Avoid

Mistake 1: Selling Calls on Stocks You Don't Want to Own

If the stock drops, you're stuck with it.

Fix: Only sell covered calls on stocks you'd happily hold.

Mistake 2: Chasing High Premiums

High premiums = high volatility = high risk of big moves.

Fix: Understand why premiums are high before selling.

Mistake 3: Ignoring Assignment Risk

Getting assigned isn't bad, but be prepared.

Fix: Be comfortable selling at your chosen strike.

Mistake 4: Selling Through Earnings

Stocks can gap significantly on earnings, whipsawing your position.

Fix: Close before earnings or accept the risk consciously.

Mistake 5: Not Managing Losers

When stock drops significantly, selling more calls at low strikes locks in losses.

Fix: Reassess the position; don't blindly keep selling.

Mistake 6: Over-Trading

Constant rolling and adjusting eats into profits.

Fix: Let positions play out; don't over-manage.

Tax Considerations

Qualified Covered Calls

If your covered call meets IRS rules, it doesn't affect the holding period of your stock.

Requirements:

• Strike price not "too far" ITM
• Expiration not too far out
• Not sold on same day as stock purchase

If Called Away

• Triggers sale of stock
• Proceeds = strike price + premium received
• Calculate gain/loss based on cost basis
• Holding period matters (short vs long-term)

Consult a Tax Professional

Options taxation is complex. Rules about:

• Wash sales
• Constructive sales
• Holding period adjustments

Get professional advice for your specific situation.

Covered Call Checklist

Before Entering

• Stock you want to own at current price?
• Willing to sell at strike price?
• Comfortable with maximum upside (strike + premium)?
• Aware of upcoming events (earnings, dividends)?
• Options liquid (tight bid-ask spread)?
• Premium justifies the risk?

Strike and Expiration

• Strike aligns with your outlook (bullish = higher strike)?
• Delta around 0.25-0.35 for balance?
• Expiration 30-45 days out?
• Avoiding earnings date?
• Dividend consideration if applicable?

Position Management

• Set alerts for price movements?
• Know your exit plan if stock rallies?
• Know your plan if stock drops?
• Tracking position daily/weekly?

Quick Reference: Covered Call Cheat Sheet

Setup

Outcomes

Management

Frequently Asked Questions

What is a covered call?

A covered call is an options strategy where you own shares of a stock and sell (write) call options against those shares. You collect premium income upfront, but agree to sell your shares at the strike price if the option is exercised. It's "covered" because you own the underlying stock.

How much money can you make selling covered calls?

Covered call income varies based on volatility, time to expiration, and strike selection. Typical monthly returns range from 1-3% of the stock's value. Annual yields of 8-15% are achievable in normal markets. Higher volatility means higher premiums but also higher risk of assignment.

What happens if a covered call expires worthless?

If the stock price stays below the strike price at expiration, the call expires worthless. You keep the full premium as profit and still own your shares. You can then sell another covered call to generate more income. This is the ideal outcome for covered call sellers.

What are the risks of covered calls?

Main risks: 1) Opportunity cost if stock rises above strike (you miss upside), 2) Stock can still decline (premium provides limited protection), 3) Early assignment near ex-dividend dates, 4) Stock called away at inconvenient time. You also still bear full downside risk of stock ownership.

When should you not sell covered calls?

Avoid covered calls when: you expect significant upside (you'll cap gains), the stock is volatile with binary events (earnings, FDA), you don't want to potentially sell shares (tax consequences), or premiums are too low to justify the risk. Also avoid on stocks you wouldn't want to own long-term.

Related Articles

Expand your options and income knowledge:

• Dividend Investing Guide — Combine dividends with covered call income
• Stock Order Types — Execute options trades properly
• Trading Risk Management — Position sizing for options
• ETF Investing Guide — Sell covered calls on ETFs
• How to Build a Watchlist — Find covered call candidates