Options Strategy Basics: Looking Under the Hood of Covered Calls

Learn how a covered call options strategy can attempt to sell stock at a target price; collect premium and potentially dividends; and limit tax liability.

https://tickertapecdn.tdameritrade.com/assets/images/pages/md/Under the hood of covered call options strategies
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Key Takeaways

  • Covered calls can be part of a trade exit strategy, but know the risks
  • Understand how dividends affect options prices and options strategy
  • There may be certain tax advantages to selling covered calls

Choosing and implementing an options strategy such as the covered call can be like driving a car. There are a lot of moving parts, but once you’re familiar with a few basics, you can steer toward your objective. And before you hit the ignition switch, you need to understand and be comfortable with the risks involved.

What draws investors to a covered call options strategy? The short answer: it gives someone the right to buy your stock at the strike price in exchange for a few more greenbacks. Covered calls can potentially earn income on stocks you already own. Of course, there’s no free lunch; your stock could be called away at any time during the life of the option. But selling (or “writing”) covered calls has many other potential uses that many investors don’t fully realize. 

So let's pop the hood and look at three features of this basic options strategy: selling stock, collecting dividends, and potentially limiting taxes.

1. Exit a long position.

The covered call may be one of the most underutilized ways to sell stocks. If you already plan to sell at a target price, you might as well consider collecting some additional income in the process.

Here’s how it works. Let’s say that XYZ stock is trading at $23 per share and you want to sell your 100 shares at $25 per share. Sure, you could probably sell your XYZ shares right now for $23 per share in your brokerage account, but you could also sell (write) a covered call with your target price (strike price) of $25 per share. Take a look at the covered call risk profile in figure 1. 

If you sell the call, you’ll receive cash (premium), which is immediately deposited into your account (less any transaction costs). The cash is yours to keep no matter what happens to the underlying shares. If XYZ rises above $25 before the option expires, you’ll likely be assigned on your short option and your shares of XYZ will be called away from you at the strike price. In fact, that move may fit right into your plan. You received a premium for selling the call, and you also made an additional two points (from $23 to $25) on the stock.

FIGURE 1: COVERED CALL RISK GRAPH. Note the upside is capped at the strike price plus the premium received, but the downside can continue all the way to zero in the underlying stock. For illustrative purposes only. 

As desired, the stock was sold at your target price (i.e., called away from you) at $25. If the stock goes higher than $25, you made what you wanted, but not a penny more. After all, you agreed to sell XYZ at $25. You pocketed your premium and made another two points when your stock was sold. But you won’t participate in any stock appreciation above the strike price. Also, keep in mind that transaction costs (commissions, contract fees, and options assignment fees) will reduce your gains.

ON THE OTHER HAND—In our example, although you'd like to sell XYZ at $25, it’s possible that the stock price could fall instead, perhaps from $23 to $20 or even lower. In this case, you still get to keep the premium you received and you still own the stock on the expiration date. But instead of the two points you hoped to gain, you’re now looking at a potential loss (depending on the price at which you originally bought XYZ). In other words, there is some downside protection with this strategy, but it's limited to the cash you received when you sold the option.

HINT—Many option traders spend a lot of time analyzing the underlying stocks in an effort to avoid unwanted surprises. They use that research to try to improve the odds of choosing stocks that won’t suffer a serious, unexpected price decline. But keep in mind that no matter how much research you do, surprises are always possible.

ANOTHER HINT—Whenever your covered call option is at the money (ATM) or in the money (ITM), your stock could be called away from you. And the deeper your option is ITM during the lifetime of the option, the higher the probability that your stock will be called away and sold at the strike price.

KEEP IN MIND—If your option is ITM by even one penny when expiration arrives, your stock will likely be called away.

2. Sell covered calls for premium; potentially continue to collect dividends and capital gains.

Selling covered calls can sometimes feel like you’ve made a triple play. After you sell a covered call on XYZ, you collect your premium, and you still receive dividends and capital gains on the underlying stock (unless it’s called away). That’s the good news.

ON THE OTHER HAND—The option buyer (the person who agreed to buy your option) may also want that dividend, so as the ex-dividend date approaches, the chances increase that your stock will be called away.

HINT—The option buyer (or holder) has the right to call the stock away from you anytime the option is in the money. You still keep the premium and any capital gains up to the strike price, but you could miss out on the dividend if the stock leaves your account before the ex-dividend date.

ANOTHER HINT—Not surprisingly, some option buyers will exercise the call option before the ex-dividend date to capture the dividend for themselves. And if the option is deep ITM, there’s a higher probability the stock will be called away from you before you get to collect the dividend. Anytime you sell a call option on a stock you own, you must be prepared for the possibility that the stock will be called away. When you sell a covered call, you receive premium, but you also give up control of your stock.

KEEP IN MIND—Though early exercise could happen at any time, the likelihood grows as the stock's ex-dividend date approaches. To view ex-dividend dates in the thinkorswim® platform from TD Ameritrade, under the MarketWatch tab, select Calendar and check the Dividend box. 

3. Get potential tax advantages by selling covered calls.

There may be tax advantages to selling covered calls in an IRA or other retirement account where premiums, capital gains, and dividends may be tax-deferred. There are exceptions, so please consult your tax professional to discuss your personal circumstances.

If the stock is held in a taxable brokerage account, there are some tax considerations. 

FOR EXAMPLE—Let’s say in November you have potential profits on XYZ stock, but for tax purposes, you don’t want to sell. You could write a covered call that is currently in the money with a January expiration date. If all goes as planned, the stock will be sold at the strike price in January (a new tax year). Remember, you’re always accepting the risk, no matter how small, that your option will be assigned sooner than you planned. One way to reduce that probability but still aim for tax deferment is to write an out-of-the-money covered call.

ON THE OTHER HAND—If the stock falls rather than appreciates, you'll likely still be holding the stock and the call option will expire worthless. You could always consider selling the stock or selling another covered call. Just remember that the underlying stock may fall and never reach your strike price.

HINT—Given a choice between paying taxes on a profitable stock trade and paying no taxes on an unprofitable stock trade, most people would rather pay the taxes. But that's a choice only you can make.

ANOTHER HINT—If you believe that the benefits of selling covered calls outweigh the risks, you might look for stocks that you consider good candidates for covered call writing. A buy-write allows you to simultaneously buy the underlying stock and sell (write) a covered call.

KEEP IN MIND—You'll likely pay two commissions, one for the buy on the stock and one for the write of the call. Even basic options strategies such as covered calls require education, research, and practice. Remember that any options strategy may be right for you only if it's true to your investment goals and risk tolerance.

Want more info on the covered call strategy? Watch the video below.

Investing Basics: Covered Calls
The information presented is for informational and educational purposes only. Content presented is not an investment recommendation or advice and should not be relied upon in making the decision to buy or sell a security or pursue a particular investment strategy.
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Key Takeaways

  • Covered calls can be part of a trade exit strategy, but know the risks
  • Understand how dividends affect options prices and options strategy
  • There may be certain tax advantages to selling covered calls
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A covered call strategy can limit the upside potential of the underlying stock position, as the stock would likely be called away in the event of substantial stock price increase. Additionally, any downside protection provided to the related stock position is limited to the premium received. (Short options can be assigned at any time up to expiration regardless of the in-the-money amount.)

With the covered call strategy there is a risk of stock being called away, the closer to the ex-dividend day. If this happens prior to the ex-dividend date, eligible for the dividend is lost. Income generated is at risk should the position moves against the investor, if the investor later buys the call back at a higher price. The investor can also lose the stock position if assigned

The maximum risk of a covered call position is the cost of the stock, less the premium received for the call, plus all transaction costs.

Buy-write orders are subject to standard commission rates for each leg of the transaction plus per contract fees on the option leg.

TD Ameritrade does not provide tax advice. We suggest you consult with a tax-planning professional with regard to your personal circumstances.



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