The Covered Call: An Income-Generating

Options Strategy
by Michael C. Thomsett
The covered call provides extra income to a buy-and-hold strategy. In exchange for this income,
there is a risk of lost opportunity. If the stocks price rises well above the fixed strike price of the
call, you have your 100 shares of stock called away below current market value. For some
investors, this is an unacceptable risk; for others, it is gladly accepted given the potential extra
returns from writing covered calls.

A Few Options Basics

The popularity of options trading has grown in recent years. Many investors and traders have
realized that options can be used not only to speculate, but also as a means for managing a longterm stock portfolio, taking profits without needing to sell stock, and reducing the threat of losses.
Among the dozens of possible strategies, covered call writing is especially popular for its potential to
generate extra income for a portfolio.
Options are intangible contracts that provide rights to their owners. A call option provides the right to
buy shares. (The second type of option, the put, gives you the right to sell.) The stock involved in
every call trade is the underlying security. Call options have two other specifications: the expiration
date (the date on which an option expires and becomes worthless) and the strike price (the price per
share at which 100 shares of an option can be bought or sold when exercised). None of these terms
can be changed.
A buyer, or owner, of an option has the right to exercise the contract. In the case of a call, this means
that the right involves calling away, or purchasing, 100 shares of the stock at the strike price. For
example, if you own a 70 call and the underlying stock moves to $85 per share, that call gives you
the right to buy 100 shares at $70, or $15 per share below current market value.
Call buyers take considerable risk. About 75% of all calls expire worthless, so buying is a speculative
strategy. Some traders use options to time entry and exit points to take advantage of short-term
price changes, but as expiration nears, the option loses value.
This happens because part of the options premium (the current value of the option), its time value,
falls, ending up at zero on expiration day. The rate of decline accelerates as expiration approaches,
making buying options a difficult way to profit consistently. (The time to expiration impacts value

because the longer the period to expiration, the greater the probability that the stock will reach and
move beyond the exercise price. As the expiration date nears, time value decreases because there
are fewer days during which the contract can be exercised before it expires.) Time value is a big
problem for call buyers.
Selling options is a more profitable approach, for two reasons. First, when you sell an option, you
receive the premium instead of paying it. Second, the decline in time value is an advantage to you
as a seller. As time value declines, a short call can be closed, creating a profit. This profit is the
difference between the original sale price (the options premium) and the lower closing purchase
price. (When you write, meaning sell, an option contract, you are short the contract. The term short
call refers to the fact that you want the call contract to decrease in value, to $0, after you have sold
it.)

Selling Call Options

You can write a call that is covered, meaning you own the underlying shares, or uncovered,
where you do not already hold the shares.

The Risky Uncovered Call

Selling an uncovered, or naked, call is one of the riskiest option strategies because a stocks price
can rise as high as the market moves it. One huge problem with selling calls when you do not own
100 shares of the underlying security is the high risk involved.
For example, if you sell an uncovered 70 call (strike price is $70 per share) and you get a premium
of 4 ($400), as long as the stock price remains at or below $70, all of the premium is going to be
profit. But what if the stocks value rises to $95 before the option expiration date? In that case, you
would have a net loss of $2,100 because you would need to buy the stock at the prevailing price of
$95 in order to deliver it at the previously contracted price of $70. Table 1 shows the math.
Table 1. Example of an Uncovered Call Resulting in a Large Loss
Price for 100 shares @ $95 per share

$9,500

Less: exercise price of 100 shares with a 70 strike

$7,000

Loss on the stock

Less: premium received for selling the call
Net loss on the uncovered call

$2,500
$400
$2,100

The risk of selling an uncovered call is unacceptable for most traders, even though 75% of all calls
expire worthless. If the stock price rises, the market risk is simply too great.

The Covered Call Alternative

Just as the uncovered call is a high-risk strategy, the covered call is on the other side of the risk
spectrum, relatively speaking. It is one of the most conservative options strategies.
The primary argument against the covered call is that if the stock price rises above the strike price,
profits on the stock are limited to the price specified in the contract. In other words, no matter how
high the stock trades, you can only sell the stock at the price specified in the contract, which is the
strike price.

Examples of Covered Calls

The first rule for covered call writing: Pick the company as a first step, based on your investment
standards and risk tolerance. This is a huge subject area beyond the scope of covered calls; but it is
invariably a mistake to use covered call writing as a primary method for picking stocks.
Assume that you have two stocks you are considering for your portfolio. In both cases, you are
happy to hold these stocks for the long term but, given the right premium levels for covered calls,
you are also happy to risk having shares called away.

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Two stocks are used in the following examples: IBM IBM and Caterpillar CAT. A position of 100
shares in IBM purchased at $120 per share and a position of 100 shares in CAT purchased at $58
per share is assumed. Based on the stock and option values at the close of June 30, 2010, IBM
closed at $123.48 and yielded a dividend of 2.1%. Caterpillar closed at $60.07 and yielded a
dividend of 2.9%.
The IBM calls available as of the June 30 close are based on a limited range of strikes between 125
and 135 expiring in the three closest expiration months. The CAT calls are based on strikes between
60 and 65 expiring in the three closest expiration months. These months are always the two closest
months and the next following month in a stocks expiration cycle. IBMs cycle is JAJO (January,

April, July, October), while CATs cycle is FMAN (February, May, August, November). Calls for both
stocks are summarized in Table 2.
Table 2. Option Values for IBM and CAT as of June 30, 2010
IBM Calls

Strike

Premium ($)

Price

($)

July
Expiration

August
Expiration

October
Expiration

125

2.03

4.31

6.35

130

0.52

2.31

4.25

135

0.11

1.01

2.56

CAT Calls
Strike

Premium ($)

Price
($)

July
Expiration

August
Expiration

November
Expiration

60

2.32

4.00

6.30

62.50

1.23

2.85

5.50

65

0.54

1.90

4.05

The next step is to pick the best strike. All of these are above the purchase price for each of the
stocks. However, the premium levels are quite different. The longer the time to expiration, the higher
the dollar value of the call for the contract closest to the stocks current pricebut the lower the
annualized yield.
To annualize, calculate the yield by dividing the option premium by the current stock price. Then,
divide the yield by the holding period (in months) and multiply by 12 (months). This creates the yield
earned if the position were kept open exactly one full year. Note that because the date of these
options is June 30, the time to the July expiration is 23 days, which makes the holding period about
75% of one month.Table 3 shows the math for calculating the annualized yield based on
comparisons between the option premium and current value of the stock for each of the options.
Table 3. Calculating Annual Yield on Options
IBM Options, Annualized Yield

July (0.75 month):

125:

(2.03 123.48 ) 0.75 x 12

26.3%

130:

(0.52 123.48 ) 0.75 x 12

6.7%

135:

(0.11 123.48 ) 0.75 x 12

1.4%

August (1.75 months):

125:

(4.31 123.48 ) 1.75 x 12

23.9%

130:

(2.31 123.48 ) 1.75 x 12

12.8%

135:

(1.01 123.48 ) 1.75 x 12

5.6%

125:

(6.35 123.48 ) 3.75 x 12

16.5%

130:

(4.25 123.48 ) 3.75 x 12

11.0%

135:

(2.56 123.48 ) 3.75 x 12

6.6%

60:

(2.32 60.07 ) 0.75 x 12

61.8%

62.50:

(1.23 60.07 ) 0.75 x 12

32.8%

65:

(0.54 60.07 ) 0.75 x 12

14.4%

60:

(4.00 60.07 ) 1.75 x 12

45.7%

62.50:

(2.85 60.07 ) 1.75 x 12

32.5%

65:

(1.90 60.07 ) 1.75 x 12

21.7%

60:

(6.30 60.07 ) 4.75 x 12

26.5%

62.50:

(5.50 60.07 ) 4.75 x 12

23.1%

65:

(4.05 60.07 ) 4.75 x 12

17.0%

October (3.75 months):

CAT Options, Annualized Yield

July (0.75 month):

August (1.75 months):

November (4.75 months):

Annualized returns should not be used as a yardstick to judge the value of all covered call writing.
For example, a CAT July 60 call shows annualized yield of 61.8%, which is quite impressive.
However, this does not mean that writing a series of similar calls is going to produce that rate of
return over the coming year. Movement in the stock, changes in markets, and the timing between
entry date and expiration make actual returns less certain. However, annualized yield in options
analysis is valuable for making accurate comparisons between companies.
In the example above, the yields on Caterpillar are vastly higher than the yields on IBM. This means
CAT is a more volatile stock, and thus includes higher market risks than IBM. So the decision to use
one company or the other for writing covered calls is a matter of matching the market risk of the
stock to the risk tolerance of the individual investor.
A second comparison can be made on dividend yield. Based on the June 30 prices, IBM yielded
2.1% whereas CAT yielded 2.9%. This difference in dividend should also affect the decision to use
one stock over the other. The rationale is that the higher yield will produce more relative income.
Assuming you would have picked Caterpillar as a purchase choice, the next step is to compare
available options. Table 3 shows that shorter-term options yield better returns than longer-term

options. The CAT 60 July call offers comparatively more upside. It yields over 60% annualized while
generating immediate income of $232 (the premium payment). Exposure time is about 23 days. If
the stock price closes below $60 per share, this call would expire worthless. If exercised, the call
writer keeps the $232 plus dividends, plus a capital gain of $200 ($60.00 $58.00).
These examples use calls that are above the purchase price of the stock. Writing covered calls on a
stock whose price has declined below your original purchase price is not recommended. The profit
from selling calls with strikes above the price you originally paid for the stock will not be large
enough to offset your loss in the stock itself. In this situation, you need to wait out the market until
the value of the stock rises above your original cost basis.

Evaluations and Comparisons

Comparing premium income on an annualized basis as well as dividend yield creates valid
comparisons in picking a covered call. Here are some additional things to consider when deciding
whether or not covered call writing is an appropriate strategy for you:

What are the transaction costs for trading? Calls are quite cheap when compared to stocks;
and the trading costs involved are quite low. A round-trip (buy and sell) for a call should be
less than $20 if you use an online discount broker.

How about tax consequences? Income from a covered call is always treated as a short-term
capital gain or rolled into the capital gain on exercised stock. A more serious tax consequence
is the possibility of losing the benefit of long-term gains treatment. If you sell a call that is
lower than one increment from latest closing price in most cases (meaning the strike is well
below the stocks current market value), you could be required to treat the gain as a shortterm profit. IRS Publication 550 discusses tax issues involving options.

Does it make more sense to just sell the stock? Not every investor holding 100 shares of
stock should write covered calls. In some cases, you are better off selling shares and taking
profits. If the criteria for holding a companys stock have changed, it makes sense to sell right
away and replace it with shares of a company that do meet your criteria. It may also make
sense to take profits when you have a substantial net loss in another transaction, so that
losses and profits are offset in the same tax year. And it makes sense to sell when a sector is
cyclically moving out of favor or when another company in the same sector has greater
growth potential. Covered calls should be written only on shares of companies you would
prefer to keep in your portfolio.

Common Options Terms

Call: An option granting its owner the right, but not the obligation, to buy 100 shares of a specified stock, by or before
a specific date, and at a specific fixed price.

Covered call: A strategy of selling one call per 100 shares owned of the underlying security. If exercised, the market
risk is eliminated because shares are available to be called away. Covered call writers receive the premium and earn
dividends as long as they own the stock.
Exercise: Using an option to trade in the underlying security. This entitles the call owner to buy (or, call away) 100
shares of stock.
Expiration cycle: The months in which options are going to expire. There are three annual cycles: JAJO (January,
April, July, October); FMAN (February, May, August, November); and MJSD (March, June, September, December).
Expiration date: The date on which an option expires and becomes worthless.
Premium: The current value of an option; the amount a buyer has to pay to acquire an option, or the amount a seller
receives.
Strike price: The price per share at which 100 shares of stock can be bought or sold when an option is exercised.
Time value: The portion of an option premium based on time to expiration; as expiration approaches, time value
declines at an accelerated pace.
Uncovered call: An option contract sold by an investor who does not own 100 shares of the underlying security.
Underlying security: The stock or other security the option contract is written on, which cannot be exchanged or
replaced.

Four Outcomes
A covered call is going to end up in one of four ways:
1. The call option expires worthless. This means that the premium you received is 100%
profit. As soon as a call you wrote (aka a short call) expires, you can immediately write
another call and generate even more short-term income.
2. You close the position at a profit or to limit a loss. You are free to close a call option you
wrote (aka a short call) any time before expiration. If the calls premium drops
substantially, it might make sense to execute a closing purchase transaction by buying a
call with the same strike price and expiration as the one you wrote, take the profit, and
then write later-expiring calls. If the stock price has risen, you can also close a short call
to limit losses. This is a logical choice when the loss on the short call is lower than the
appreciation in the underlying stock.
3. The short call is exercised. This can happen at any time, but is most common on the last
trading day of the expiration month. In the case of exercise, your 100 shares are called
away and your net profits include capital gains, the option premium and dividends.
4. The short call is rolled forward. You can avoid or delay exercising with a forward roll, a
transaction in which you close one call and replace it with another that expires later. A
word of caution: The forward roll can unintentionally turn a qualified covered call into an
unqualified covered call. A qualified covered call does not change the tax status of the
underlying stock, whereas an unqualified covered call can. If you are close to reaching
long-term capital gains status on your shares of stock, but your roll creates a new
position with a strike more than an increment below current market value, the period
counting toward favorable long-term treatment stops. In other words, if the stock is

called, you could end up paying taxes on short-term gains regardless of how long you
have held the stock. Consult a tax professional about how a covered call strategy will
impact your tax situation.

Guidelines
Here are five guidelines for writing covered calls:
1. Select the stock as a first step. Never buy stock only to write covered calls; apply a
sensible standard for picking companies whose stock you want to own.
2. Be willing to accept exercise. When you sell a covered call, you are granting the right to
someone else to call away your stock. You need to be happy selling 100 shares at the
strike price.
3. Pick a strike higher than the price you paid for the stock. If a covered call is exercised, it
should yield a capital gain and not a capital loss. For example, if you buy shares at $69,
look at calls with strikes of 70 or above. Avoid writing covered calls with strikes below
your cost. Your broker will have a table showing contracts for various months.
4. Include dividends in the comparison. When comparing the income from covered calls,
remember that dividends represent part of the overall return. So for two or more stocks
you might buy, if the fundamentals are approximately equal, opt for the higher-yielding
company.
5. Make sure you can accept lost opportunity risk. Exercise means you lose the potential for
higher capital gains in the stock. So, you must be willing to lose the occasional big profit
in a stock in exchange for the income from covered call writing.
Evaluate covered call writing like any other option strategy: Be aware of the risks. For covered calls,
you live with the lost opportunity risk or the sacrifice of potential profits you could earn by just owning
stock when the price rises dramatically. The covered call fixes your sales price at the strike in
exchange for the call premium you receive.
Other important risks are knowledge risk (the risk of entering transactions when you do not fully
understand what is involved); capital risk (the need to keep money tied up in the long stock to cover
the short option); and the potential risk of having stock called away that you want to keep.
With these risks in mind, if you want to write covered calls, you need to make sure you are willing to
accept the premium in exchange for the potential of losing a large capital gain. You also need to
make sure you understand the transaction. Finally, you need to know in advance that having stock
called away at the strike is an acceptable outcome