Selling covered calls on stock you would sell anyway

In short

A friend of mine once told me he wanted to get paid for waiting, and I have thought about that line more than once. If you are holding shares you would happily sell at a higher price, a covered call lets you collect cash today for agreeing to do just that. The buyer of the call pays a premium, which is money that is yours to keep no matter what happens next. In return, you promise to hand over your shares at a set price if the buyer asks. Your gain from the shares is capped at that price, so a big jump in the stock goes to the buyer, not to you. Nothing here is a free lunch. It is a trade of some future upside for money in hand.

The whole of it

What it is

I once watched a neighbor sell the right to pick apples from his orchard in October. He took the money in August and slept fine, because he knew the apples would be sold anyway. A covered call works a bit like that. You own 100 shares of a stock, and you sell someone a call option on those shares. An option is a contract. The call gives its buyer the right, but not the duty, to buy your 100 shares at a fixed price called the strike price, any time before a set date called the expiration.

The word covered matters. It means you already hold the shares, so you can deliver them if asked. Selling a call on shares you do not own is a different and far riskier act, and it is not the subject here.

Each contract covers 100 shares. The money the buyer pays you is the premium. It lands in your account the day you sell, and you keep it whether or not the shares are ever called away.

If you are the sort of person who already had a sell price in mind, this tool may feel natural. You were going to let the shares go at that price anyway. Now you get paid something for saying so out loud.

How it works

You have probably set a target before, a price where you said, I would be glad to sell right there. The covered call turns that target into a contract. Say you pick a strike price near your target and an expiration a month or two away. You sell the call and collect the premium. Then one of two things happens at expiration.

If the stock finishes below the strike price, the buyer has no reason to use the call. It expires worthless. You keep your shares and you keep the premium. You can sell another call if you like, or not.

If the stock finishes above the strike price, the buyer will almost surely use the call. This is called assignment. The seller must deliver the shares at the strike price. You get the strike price for each share, plus the premium you already took. The shares are gone, and so is any gain above the strike.

An option can also be assigned early, before expiration, though that is less common and tends to happen around dividend dates. Your broker will tell you if it happens. You can also close the position yourself by buying back the call, which costs money and may leave you with a loss on the option.

The key idea is the trade. You give up the thrilling upside above the strike. In return you get a small, certain payment now. The premium also cushions a small fall in the stock, but only by the amount of the premium. If the shares drop a lot, the premium will not save you.

The numbers, and where to find yours

Your own numbers sit in two places. The first is your brokerage account, which shows how many shares you own, your cost basis, and your holding period. Cost basis is what you paid for the shares, and it drives your tax bill when they sell. The second is the options chain, a table your broker shows for each stock. It lists strike prices, expiration dates, and the premium buyers will pay today.

Taxes deserve a careful look, and the rules change by year and by person. Whether a gain counts as long term or short term depends on how long you held the shares. The long term capital gains rate and its income brackets are set by law and updated, so check the current figures with the IRS. The right place is IRS Publication 550, Investment Income and Expenses, along with Form 8949 and Schedule D instructions. When an option expires worthless, the rules for reporting the premium are set out in IRS Publication 550, and the treatment depends on the facts of the trade. When shares are called away, the premium is generally added to your sale price. There are special rules that can reset or pause the holding period of your shares, and they depend on how far the strike sits from the stock price. This is the spot where many people get surprised, so read Publication 550 or ask a tax professional before you act.

Watch your fees too. Brokers charge a per contract fee, and the gap between the buying and selling price of an option, called the spread, is a real cost. Both cut into a small premium.

A worked example

Let me tell you about Margaret, a retired schoolteacher in Ohio. She owns 200 shares of a company she bought years ago. The shares trade at $48 each. She told her daughter she would be glad to sell at $52, and not a penny sooner.

Margaret looks at the options chain. A call with a $52 strike, expiring in 45 days, pays a premium of $0.90 per share. She sells two contracts, one for each 100 shares. The math is 200 shares at $0.90 each, which is $180. She pays a fee of $1.30 per contract, so $2.60 total. Her net premium is $180 minus $2.60, which is $177.40.

Now the two endings. In the first, the stock sits at $50 on expiration day. That is below $52, so the call expires worthless. Margaret keeps her 200 shares and the $177.40. Her shares are worth 200 times $50, or $10,000, so she holds $10,000 in stock plus $177.40 in cash.

In the second ending, the stock climbs to $58. The buyer uses the call. Margaret must sell her 200 shares at $52. That is 200 times $52, or $10,400. Add the $177.40 premium and she has $10,577.40. If she had just held the shares, they would be worth 200 times $58, or $11,600. The gap is $11,600 minus $10,577.40, which is $1,022.60. That is the upside she traded away.

Notice what she did not lose. She sold at $52, the very price she wanted. She was paid $177.40 for the promise. Whether that was a fair deal depends on how she feels about the missed $1,022.60. Some folks will shrug it off. Others will lie awake. Know which you are before you sign.

Where it goes wrong

A man I knew sold calls on a stock he loved, a stock he truly never wanted to part with. Then it jumped, the shares were called away, and he spent a year grumbling. The tool did exactly what it said. His heart simply was not in the bargain. So the first mistake is writing a covered call on shares you would hate to lose.

The second mistake is thinking the premium is free money. It is payment for capping your gain. A stock that rises sharply will leave you behind. A stock that falls sharply will hurt you almost as much as if you had sold no call at all. The premium only softens the blow by its own small size.

Taxes bite people too. A called away sale can trigger a gain you did not plan for, and it may land in a year you did not expect. It can also affect whether a gain counts as long term. Check Publication 550 first.

Then there are the quiet costs. Fees and wide spreads can eat a thin premium. Early assignment can arrive when you least expect it. And if you sell calls on shares held in a retirement account, the rules and the approval your broker requires can differ from a regular account. Ask your broker what level of options approval is needed.

A friend of mine once lost a dividend he had counted on. When a call is used just before a dividend date, the buyer who now owns the shares collects that dividend, not the seller.

Questions to answer before you leave this page

Would you truly be glad to sell these shares at the strike price, with no regret if the stock soars past it? Do you know your cost basis, and have you worked out what tax bill a sale at that price would create? Have you read IRS Publication 550 or spoken with a tax professional about how option premium and holding periods are treated? Can you say in plain words how much upside you are giving up, and does that number sit easily with you? Have you counted the fees and the spread on this particular option, and does the premium still look worth it afterward? Does your account allow covered calls, and have you asked your broker what approval level it requires? What will you do if the shares are called away early, and what will you do with the cash?