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Lesson 10 · Options

Covered Call Strategy Explained

  • 12 short cards
  • About 6 min to read
  • 5 quiz levels · 30 questions
  • Intermediate

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Overview

A covered call strategy means owning shares and selling someone the right to buy them from you at a set price. You get paid for that right straight away. In return, if the share price rises above that set price, you give up the extra gain.

Timeframe
Options lasting about a month
Markets
Shares and ETFs with listed options
Difficulty
Intermediate

Builds on: Trading for Beginners: The Basics, Position Sizing and the 1% Rule in Trading

The payoff on a chart

-20-100+1080859095100105110115120Share price at expiryStrike 105TodayBreakeven 98.00Max profit +7.00
  • Profit or loss per share at expiry
  • Profit zone
  • Loss zone
  • Breakeven

Profit or loss when the option expires, per share. You bought the shares at $100 and sold a $105 call for $2. You break even at $98, and profit is capped at $7 per share.

What is an option?

An option is a contract that gives its buyer a right, but not a duty, to buy or sell something at a fixed price before a set date3.

A call option is the right to buy. The fixed price is the strike price, and the last day is the expiry date. The buyer pays the seller a fee called the premium3.

A standard US share option covers 100 shares. Most US share options can be used, or exercised, on any day up to expiry2. When a buyer exercises, the seller must sell the shares at the strike price. This is called assignment2.

Selling one call option, step by step

  1. You sell the callStrike $105, expiry in 35 days
  2. You’re paid now$2.00 × 100 shares = $200 premium
  3. The buyer has a rightTo buy your 100 shares at $105, up to expiry
  4. At expiryBelow $105: worthless. Above $105: usually exercised

How a covered call works

You own 100 shares and sell one call option on them1. It is called “covered” because you already own the shares you might have to hand over.

You keep the premium whatever happens. If the share price is below the strike at expiry, the option is worthless and you keep both the shares and the premium.

If the share price is above the strike, the buyer will usually exercise. You sell your shares at the strike price, and your gain is capped.

What happens at expiry

Share price below the strike

  • The option expires worthless
  • You keep the shares
  • You keep the premium

Share price above the strike

  • The buyer usually exercises
  • You sell your shares at the strike (assignment)
  • You keep the premium, but your gain is capped

Maximum profit, breakeven and risk

Maximum profit = (strike price − what you paid for the shares) + premium4.

Breakeven = what you paid for the shares − premium4.

You still own the shares, so you keep almost all of the risk if they fall. The premium only softens a small fall. It doesn’t protect you from a big one.

Worked example: maximum profit and breakeven

You paid for the shares
$100
Strike price
$105
Premium received
$2
Maximum profit per share: ($105 − $100) + $2
$7
For 100 shares
$700
Breakeven: $100 − $2
$98

Below $98 you lose money, just as you would owning the shares, only $2 a share less.

Choosing the strike and expiry date

A strike well above today’s price pays a smaller premium but leaves more room for the shares to rise. A strike close to today’s price pays more, but you are more likely to have to sell your shares.

An option loses value as expiry gets closer, which helps the seller. This is called time decay. It tends to speed up in the final weeks, especially for options with a strike near the share price3. Many sellers pick options about 30 to 45 days from expiry.

Watch dividend dates. A dividend is cash a company pays its shareholders. To get it, you must own the shares before the ex-dividend date. Call buyers sometimes exercise early to collect a dividend, so your shares may be taken just before that date2.

Choosing a strike (made-up premiums, share at $100)

StrikePremiumRoom to riseChance of selling your shares
$102$3.50$2Higher
$105$2.00$5Middle
$110$0.80$10Lower

A closer strike pays more but caps you sooner. A further strike pays less but leaves more room.

Covered call rules

Entry

  • Own (or buy) 100 shares for each option you sell.
  • Sell one call about 30–45 days from expiry, with a strike above today’s share price.
  • Only use shares you would be happy to sell at the strike price.

Exit

  • Let the option expire worthless, then sell another, or
  • Buy it back early once most of the premium has been earned, or
  • If the share rises above the strike, accept selling your shares, or “roll” the option.

Risk

  • You keep almost all the risk of the shares falling.
  • Avoid selling a call over company results if you want to keep your shares.
  • Check how options and share sales are taxed where you live.

Worked example: three possible endings

  1. You buy 100 shares at $100. You sell one call with a $105 strike, expiring in 35 days, for $2.00 per share. You receive $200.
  2. Ending 1, share at $98 at expiry: the option is worthless. You keep the $200, but the shares are down $200. You break even.
  3. Ending 2, share at $103: the option is worthless. The shares are up $300, plus the $200 premium: $500 profit.
  4. Ending 3, share at $112: your shares are sold at $105. You make $500 on the shares plus the $200 premium: $700, the most you can make. You miss out on the $700 of gains above $105.

Pros and cons of covered calls

Strengths

  • Regular income from shares you already own.
  • Lowers your breakeven price a little.
  • Works well when shares are flat or rising slowly.

Weaknesses

  • Caps your gains if the shares jump.
  • You keep nearly all the risk of a fall.
  • Having your shares taken can trigger tax or sell shares you wanted to keep.

Key terms

Option
A contract giving the right, but not the duty, to buy or sell at a fixed price before a set date.
Call option
The right to buy at the strike price.
Strike price
The fixed price in the option contract.
Premium
The price of an option, paid by the buyer to the seller.
Assignment
When the option seller must sell the shares because the buyer exercised.
Time decay
An option losing value as expiry gets closer.
Rolling
Buying back the current option and selling a new one with a later expiry or a different strike.

Sources

Numbers in the lesson, like 1, point to these sources.

  1. What Is a Covered Call? (video). The Options Industry Council.
  2. Exercising Options. The Options Industry Council.
  3. Hull, J. C., Options, Futures, and Other Derivatives (any recent edition). Textbook (Pearson).
  4. McMillan, L. G. (2012), Options as a Strategic Investment, 5th edition. Book.

Lesson complete

You have reached the end of the lesson. Now test what you learned with the five-level quiz.

Start the quiz

Quiz zone

Test yourself: Covered Call quiz

Five levels, from the basics to expert judgment. Clear each level to unlock the next.

  1. Level 1: Foundations. Recognise the strategy and its vocabulary.
  2. Level 2: Mechanics. Know how the signals and rules work, and why.
  3. Level 3: Application. Apply the rules to realistic chart situations.
  4. Level 4: Numbers & risk. Size, measure and manage the trade with real calculations.
  5. Level 5: Mastery. Judge edge cases, failure modes and market conditions.

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The questions only. Answers and explanations appear when you take the quiz above.

Level 1: Know the parts

  1. What is a covered call?

    • Owning shares and selling a call option on them
    • Buying a call option without owning the shares
    • Buying shares with borrowed money
    • Selling shares you don’t own

  2. When you sell a call option, you…

    • receive the premium
    • must buy more shares
    • pay the strike price
    • pay the premium

  3. True or false: a standard US share option usually covers 100 shares.

    True or false?

  4. The share price is below the strike at expiry. What usually happens to the call you sold?

    • It expires worthless, and you keep the premium
    • You must pay the premium back
    • You must sell your shares
    • It turns into a new option

Level 2: Understand the trade-off

  1. What is the main trade-off of a covered call?

    • You avoid all losses, but pay a fee
    • You double your gains, but double your risk
    • You earn premium, but give up gains above the strike
    • There’s no trade-off

  2. True or false: the premium fully protects you if the shares fall 30%.

    True or false?

  3. Choosing a strike further above today’s share price usually means…

    • your shares are more likely to be sold
    • a smaller premium, but more room for the shares to rise
    • no premium at all
    • a bigger premium

  4. What is time decay?

    • An option losing value as expiry gets closer, which helps the seller
    • The premium growing each day
    • A broker’s fee
    • A share losing value over time

  5. Why is it called a covered call?

    • It covers every month of the year
    • The premium covers all risk
    • You already own the shares you might have to hand over
    • An insurance company covers your losses

Level 3: Use it in real situations

  1. You own 100 shares at $50. Company results next week could send them up 20%, and you don’t want to sell your shares. What fits?

    • Sell the shares now
    • Sell five calls
    • Sell a call with a strike just above $50
    • Don’t sell a call over the results, or choose a much higher strike

  2. The share goes from $100 to $112 at expiry, and you sold the $105 call. What happens?

    • You lose the premium
    • You sell at $112
    • Your shares are probably sold at $105, and you keep the premium
    • You keep the shares and the premium

  3. Two weeks in, a call you sold for $2.00 is now worth $0.40. What do many sellers do?

    • Do nothing ever
    • Buy more shares
    • Buy it back to lock in about 80% of the premium, then sell a new one
    • Sell another call on the same shares

  4. Which share suits covered calls best?

    • One about to report results
    • One you’d be happy to keep or sell at the strike, moving steadily
    • One you don’t own
    • One you hope will double this month

  5. What is assignment?

    • When your broker closes your account
    • When you’re given more shares
    • When the seller must sell the shares at the strike because the buyer exercised
    • When the option expires worthless

  6. What does rolling an option mean?

    • Buying back the current option and selling a new one with a later expiry or a different strike
    • Letting it expire
    • Buying a call
    • Selling the shares

Level 4: Work out the payoff

  1. You sell one call option for $2.00 a share. One option covers 100 shares. How much premium do you receive, in dollars?

    Type a number (premium).

  2. You sell three calls for $1.50 a share each. How much premium do you receive, in dollars?

    Type a number (premium).

  3. You buy 100 shares at $100 and sell a $105 call for $2.00. What is the maximum profit, in dollars?

    Type a number (profit).

  4. Same trade: bought at $100, sold the $105 call for $2.00. What is the breakeven share price, in dollars?

    Type a number.

  5. Same trade. The share is at $103 at expiry. What is your total profit, in dollars?

    Type a number (profit).

  6. Same trade. The share is at $96 at expiry. What is the total profit or loss, in dollars? Type a minus sign for a loss.

    Type a number ((− for a loss)).

  7. You get $1.50 of premium on a $60 share for a one-month call. What is that premium as a percentage of the share price? Give one decimal place.

    Type a number (%).

Level 5: Think it through

  1. Which best describes the overall shape of a covered call?

    • A guaranteed monthly income
    • Capped gains with almost all of the share’s downside. It lags in big rallies and still suffers in big falls
    • The same as holding cash
    • Unlimited gains and no losses

  2. Your call is well above its strike just before an ex-dividend date. What risk rises?

    • You will get two dividends
    • Nothing changes
    • The option will disappear
    • Early assignment: the buyer may exercise now to collect the dividend

  3. What does “rolling up and out” mean?

    • Buying back the current call and selling one with a later expiry and a higher strike
    • Selling more shares
    • Letting the option expire
    • Buying a put

  4. Someone sells covered calls because “it’s free money”. What’s wrong with that?

    • Options are illegal
    • Nothing: it is free money
    • The premium is payment for giving up gains. It isn’t free
    • The premium is always too small to matter

  5. What do the rules say about tax?

    • Tax only matters for losses
    • Tax is the same everywhere
    • Options are always tax-free
    • Check how options and share sales are taxed where you live

  6. Why do many sellers pick options about 30 to 45 days from expiry?

    • It avoids all assignment
    • Longer options have no premium
    • Time decay tends to speed up in the final weeks, which helps the seller
    • Brokers only offer 30-day options

  7. The shares fall 30% while you hold a covered call. What happens?

    • You lose nothing
    • You lose only the premium
    • You lose almost as much as an ordinary shareholder, minus the premium
    • The buyer pays your loss

  8. In the worked example, the share rose to $112 and you sold at $105. What did the covered call cost you?

    • The $200 premium
    • Nothing
    • The $700 of gains above $105
    • $1,200

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