Boost Your Portfolio: Income & Diversification with Covered Calls
Covered calls are an options strategy that can boost return and support portfolio diversification. In this guide, we’ll break down how they work, walk through examples, and highlight when they may (and may not) make sense for your investment strategy.
WHAT IS A COVERED CALL?
A covered call is a stock options trading strategy where an investor sells call options on stock that they already own to generate income (in the form of an upfront “premium”).
This call option gives the buyer the right to purchase your stock at a predetermined price (“strike price”) before the option's expiration date. But there is a twist - strike prices are typically set above the stock’s market price, so if the stock price is unchanged by the expiration date, you—the seller—keep the money from the sale of the option as well as your shares! At this point, you can rinse and repeat to generate more income.
Covered calls sound straightforward, but it helps to see how they work in practice:
EXAMPLE TRANSACTION
Suppose you own 100 shares of XYZ Tech. The current market price of XYZ Tech is $50 per share.
You believe that the stock price will moderately increase over the next month, so you think this is a good opportunity to generate some additional return by selling a covered call. Let’s say you sell a one-month call option contract (each contract represents 100 shares) with a strike price of $55 for $2/share. You receive $200 in premiums.
There are three possible outcomes at the expiration date:
Outcome 1: XYZ Tech's stock price remains at $50 or above, but below $55. If the stock price stays below $55 at the expiration date, the call option expires worthless. You keep the $200 premium and retain ownership of your 100 shares of XYZ Tech. You can choose to write another covered call if you wish.
Outcome 2: XYZ Tech's stock price is above $55. If the stock rises above $55, the call option is exercised, and you'll be obligated to sell your 100 shares at $55 each. You still keep the $200 premium, and your total return from this transaction will be the $500 capital gain ([$55 - $50] x 100 shares) plus the $200 call option premium, totaling $700. (Keep in mind your taxable capital gain depends on your cost basis.)
Outcome 3: XYZ Tech's stock price falls below $50. If the stock price drops, you'll experience a loss in the value of your shares. However, the $200 premium received from selling the call option will help offset a small part of this loss. You can continue to hold the shares or consider other investment strategies.
We can draw some additional conclusions from this example:
COVERED CALLS CAN GENERATE ADDITIONAL RETURN
When you sell a covered call, you receive an option premium upfront. This “income” is yours to keep regardless of what happens with the stock. If the option expires without being exercised, you can repeat the process and continue collecting more premiums over time. If you can recur premium collection while the stock still goes up (Outcome 1), then you are boosting your return.
However, if your goal is to build steady, repeatable premium income, it’s often better to be less aggressive when pursuing premiums. Premiums are driven mainly by the strike price, and while lower strikes pay more, they increase the risk of losing your shares. So the trick is to choose strike prices that balance premiums with a lower chance of assignment. Over time, this repeatability is what makes covered calls a powerful way to enhance returns.
COVERED CALLS CAN HELP WITH DIVERSIFICATION
Outcome 2, where your shares are sold through assignment, might seem undesirable at first. But it actually highlights another strategic use of covered calls: gradually reduce large or overweight stock positions. Much like setting a limit sell order, if the stock reaches your strike price, your shares are sold.
By staggering strike prices and expirations, you can set up a gradual exit plan, reducing exposure over time while freeing capital to reinvest elsewhere. The premium acts as a bonus, providing immediate income that can also be put to work.
This strategy works best with shorter-maturity call options. That way, you avoid leaving too much upside on the table if the stock climbs well beyond your strike price, which can create regret or a feeling of “loss” for having sold too soon.
DID YOU KNOW?
Covered call writing is often disallowed for employees of companies that have trading windows.
Options strategies such as a covered call strategy may result in your underlying stock being sold at a time outside of your trading window. Therefore, taking advantage of this strategy for your current employer's stock is often not possible.
However, should you terminate employment, this disqualification is no longer of concern because you no longer have any timing restrictions of when you can sell your underlying stock.
MISUSES OF COVERED CALLS
Covered calls can be a very useful and worthy strategy in some circumstances. But in others, they can equally become traps. Covered calls are generally not advisable where:
You are holding stock that you believe has high return potential. Writing calls will only cap your upside and leave you with regret if the stock moves sharply higher.
You need cash flow. Premiums are unpredictable and unstable, so they should not be relied on for steady income, nor used to paper over a structural shortfall between income and expenses.
You want downside protection. Covered calls can be helpful when a stock is in a holding pattern, but sharp capital losses will always outweigh premiums. Covered calls can’t turn a poor investment into a good one: if a stock’s future looks weak, it’s usually better to sell it and redeploy your capital elsewhere.
CAN I WRITE COVERED CALLS ON ANY STOCK I OWN?
No. Not all stocks have viable options available for trading. To write covered calls, the stock must have listed options, and there should be an active market around them. You can check if a stock has options by searching for its options chain on a financial news or brokerage website.
Additionally, you may have employer restrictions on writing covered calls. Publicly traded companies usually put trading restrictions (blackout windows) on most of their employees to restrict the potential for insider trading. These blackout windows generally apply to all trading activities for the employer stock. Therefore, trading options on the company stock that you work for is generally not possible.
HOW DO TAXES AFFECT COVERED CALL INCOME?
In most circumstances, covered call premiums are treated as short-term capital gains in the United States, regardless of how long the option is held. While you receive the premium upfront, taxation does not occur until the option expires, is closed, or is assigned. If the option expires worthless or is bought back, the resulting gain or loss is always short-term. If the option is assigned, the premium is added to the stock’s sale proceeds, and the stock’s holding period determines whether the gain is taxed as short-term or long-term.
Because short-term capital gains are generally taxed at higher rates than long-term capital gains, understanding this distinction is important when writing covered calls. The rules can get nuanced—especially if the option is assigned close to the one-year holding threshold for the underlying stock—so it’s always best to consult a qualified tax professional for guidance on your specific situation.
WHAT TOOLS OR RESOURCES CAN HELP ME WITH COVERED CALL INVESTING?
Many online brokerages provide tools and resources to help you analyze and execute covered call trades. Additionally, financial news websites and investment blogs often share insights and strategies for covered call investing.
WHAT IF I AM NEW TO INVESTING?
A common financial myth is that stock options are only suitable for advanced or professional investors.
While options trading does require a certain level of knowledge and understanding, strategies like covered calls are accessible to individual investors with a basic understanding of stock options. With the right education and resources, investors can benefit from the income and diversification opportunities that covered calls provide.
FINAL THOUGHTS
Covered calls can be an effective strategy to either generate cash returns from a concentrated stock position or gradually diversify your portfolio.
As a tech professional, staying informed and optimizing your investments is essential. Our firm offers a comprehensive covered call service tailored to your unique needs and financial goals.
We invite you to engage with our team of financial planners and utilize our cutting-edge tools to maximize the benefits of covered call investing. Please reach out to us today to explore how we can help you achieve financial success and unlock the full potential of your investment portfolio.
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Past performance is not indicative of future returns, and investing always carries inherent risks, including the potential loss of principal capital. Any investment strategies are specific to individual clients and may not be representative of the experiences of all clients.
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