SystemTrader
OptionsBeginnerIncome

Covered Call Strategy

Generate income by selling call options against stock positions. A foundational options strategy that trades upside potential for immediate premium income.

Position
Long Stock + Short Call
Outlook
Neutral to Bullish
Max Profit
K - S₀ + C
Max Loss
S₀ - C

Overview

The covered call (also called "buy-write") is one of the most popular options strategies. You buy (or already own) 100 shares of stock and sell one call option against that position. The call premium provides immediate income, but you give up potential gains if the stock rises above the strike price.

This strategy is ideal when you have a neutral to slightly bullish outlook. If you expect the stock to stay flat or rise modestly, you keep the premium and your shares. If the stock rises above the strike, your shares are called away at the strike price—you profit, but miss further upside.

The covered call has the same payoff profile as a short put at the same strike. This equivalence (put-call parity) means both strategies have identical risk/reward characteristics, just implemented differently.

Key Insight

Premium Income
Collect option premium immediately
Capped Upside
Max profit limited to strike price

Covered Call Payoff at Expiration

This diagram shows the profit/loss at expiration for different stock prices.Hover over the chart to see exact values.

Entry Price (S₀)
$100
Buy 100 shares
Strike Price (K)
$105
Sell 1 call @ $3 premium
Breakeven (S*)
$97
S₀ - Premium = $100 - $3
Max Profit: +$8
When stock ≥ $105 at expiration
Max Loss: -$97
If stock goes to $0 (minus premium)
Covered call payoff
Profit zone
Loss zone

Research

Research on covered call strategies and their risk-return characteristics.

The Mathematics

In Plain English

The math behind this strategy is straightforward. Here's what you're actually doing:

  1. 1
    Buy 100 shares of stock at the current price (S₀)
  2. 2
    Sell 1 call option with strike price K, receiving premium C
  3. 3
    At expiration, if stock is below strike K: keep premium + shares
  4. 4
    At expiration, if stock is above strike K: sell shares at K, keep premium
  5. 5
    Breakeven price = Original stock price minus premium received

That's it. The formulas below just express this process precisely.

Technical Formulas

1
Profit at Expiration

Formula
P&L = S_T - S_0 - max(S_T - K, 0) + C

Where S_T is stock price at expiration, S_0 is initial price, K is strike, C is premium

2
Breakeven Price

Formula
S_* = S_0 - C

Stock can fall by the premium amount before you start losing money

3
Maximum Profit

Formula
P_max = K - S_0 + C

Achieved when stock price >= strike at expiration

4
Maximum Loss

Formula
L_max = S_0 - C

Achieved if stock goes to zero (premium provides partial protection)

Strategy Rules

Entry Rules

  1. 1Own (or buy) 100 shares of the underlying stock
  2. 2Sell 1 call option per 100 shares owned
  3. 3Choose strike price based on outlook (ATM, OTM, or ITM)
  4. 4Select expiration 30-45 days out for optimal time decay
  5. 5Ensure premium received is acceptable (typically 1-3% of stock price)

Exit Rules

  1. 1If stock > strike at expiration: shares called away, keep premium
  2. 2If stock < strike at expiration: keep shares and premium, can write new call
  3. 3Can buy back call early if stock drops significantly (capture most of premium)
  4. 4Roll to later expiration if want to maintain position
  5. 5Close position if stock drops below stop-loss level

Strike Selection

  1. Out-of-the-money (OTM): Higher strike, lower premium, more upside potential
  2. At-the-money (ATM): Strike near current price, balanced premium/upside
  3. In-the-money (ITM): Lower strike, higher premium, more downside protection
  4. Common choice: 1 strike OTM (delta ~0.30) for balance of premium and upside

Position Sizing

  1. Must own shares in multiples of 100 (1 contract = 100 shares)
  2. Consider position size relative to portfolio (typically 5-10% max per position)
  3. Account for potential assignment—be willing to sell shares at strike
  4. Factor in margin requirements if using margin account

Implementation Guide

Implementing a covered call strategy is straightforward with any options-capable brokerage.

1

Choose Your Underlying Stock

Select a stock you are comfortable owning. Ideal candidates are stocks you believe will remain stable or rise modestly. Avoid highly volatile stocks unless you want aggressive premium income.

Tips
  • Prefer stocks with liquid options markets (tight bid-ask spreads)
  • Consider dividend-paying stocks for additional income
  • Avoid stocks with upcoming earnings if you want predictability
2

Buy or Verify Stock Position

Ensure you own at least 100 shares. If buying, consider executing a "buy-write" order that simultaneously buys stock and sells the call.

Tips
  • Most brokerages offer combined buy-write orders
  • Check if your broker offers reduced commissions for buy-writes
  • Round lots (100 shares) are required for covered calls
3

Select Strike Price and Expiration

Choose based on your outlook. If neutral, sell ATM calls. If bullish but wanting income, sell 1-2 strikes OTM. Expiration of 30-45 days offers good balance of time decay and premium.

Tips
  • Higher strike = more upside potential, less premium
  • Shorter expiration = faster time decay, more active management
  • Check implied volatility—higher IV means more premium

Avoid selling calls right before earnings or ex-dividend dates unless you understand the assignment risk.

4

Sell the Call Option

Sell to open 1 call contract per 100 shares owned. Use limit orders to get a fair price between the bid and ask.

Tips
  • Always use limit orders, not market orders
  • Aim for mid-price between bid and ask
  • Verify the order shows as "covered" not "naked"
5

Monitor and Manage

Track your position through expiration. Decide in advance what you will do if the stock rises above the strike (let it be called) or falls (hold for next cycle).

Tips
  • Consider buying back call if it falls to 20% of original value
  • Roll out (later expiration) if you want to keep shares
  • Roll up and out if stock rallies but you want to extend

Helpful Tools & Resources

Brokers
TD Ameritrade, Interactive Brokers, Fidelity, Schwab
Analysis
OptionStrat, Options Profit Calculator, ThinkorSwim
Screening
Barchart, FinViz options screener

Strategy Variations

Explore different ways to implement this strategy, each with its own trade-offs and benefits.

Wheel Strategy

Combines covered calls with cash-secured puts. If shares are called away, sell puts to potentially buy back at lower price. Continuous income generation.

Popular income strategy for stocks you want to own long-term

Poor Man's Covered Call

Instead of owning stock, buy a deep ITM LEAPS call and sell short-term calls against it. Requires less capital but has additional risks.

Also called a "diagonal spread"

Collar

Add a protective put below the stock price while selling the call. This caps both upside and downside, often for near-zero cost.

Useful for protecting gains on appreciated stock

Systematic BXM Replication

Replicate the CBOE BuyWrite Index by selling monthly ATM S&P 500 calls. Can be done with SPY options or index options.

Documented to provide S&P-like returns with lower volatility

Consider combining multiple variations or testing them against your specific investment goals and risk tolerance.

Risks & Limitations

High(1)
Medium(2)
Low(1)
Downside RiskHigh

You still own the stock. If it drops substantially, the premium provides only partial protection. You can lose significantly more than the premium received.

Impact:
Opportunity CostMedium

If the stock rallies significantly above the strike, you miss out on gains. You keep the premium but sell shares below market value.

Impact:
Tax ComplexityMedium

Covered calls can affect the holding period and tax treatment of your stock. ITM calls may disqualify long-term capital gains treatment.

Impact:
Early AssignmentLow

American-style options can be exercised early, especially before ex-dividend dates. This can disrupt your strategy and trigger tax events.

Impact:
Understanding these risks is essential for proper position sizing and portfolio construction. Consider combining with other strategies to mitigate individual risk factors.

References

  • Merton, R.C. (1973). Theory of Rational Option Pricing. Bell Journal of Economics and Management Science, 4(1), 141-183 [Link]
  • Guo, I. & Loeper, G. (2020). The Volatility Risk Premium: An Empirical Study on the S&P 500 Index. SSRN Working Paper [Link]
  • Israelov, R., Klein, M. & Tummala, H. (2017). Covering the World: Global Evidence on Covered Calls. Journal of Portfolio Management, 43(4), 39-51 [Link]
  • Feldman, B. & Roy, D. (2005). Passive Options-Based Investment Strategies. Journal of Investing, 14(1), 66-83
  • Figelman, I. (2008). Expected Return and Risk of Covered Call Strategies. Journal of Portfolio Management, 34(4), 81-97
  • Israelov, R. & Nielsen, L.N. (2015). Covered Call Strategies: One Fact and Eight Myths. Financial Analysts Journal, 71(6), 45-57

Options trading involves significant risk and is not appropriate for all investors. Before trading options, read the Characteristics and Risks of Standardized Options document. Past performance does not guarantee future results.

Ready to explore more options strategies?

Learn protective puts, straddles, spreads, and more advanced options strategies.

Browse Options Strategies