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Covered call Explained
By Nicole Gibillini, Read bio | Updated on June 5, 2026
Summary
Like any investment strategy, covered calls carry risks and don’t fully protect against market losses. Before implementing a covered call, investors should assess whether this strategy matches their long-term goals and current risk tolerance.
Table of Contents
Understanding covered call
Many investors think there are two ways to make money off stocks – earn dividends and sell shares that have increased in price. But there is another approach: covered calls.
This investment strategy involves selling another investor the right to buy shares you own at an agreed upon price before a specified date. Here’s how this strategy works.
Introduction to Covered Calls
What Is a Covered Call
A covered call is when you sell (or “write”) call options against an asset (like shares of a stock) you already own to generate income. A call option is a financial contract giving the buyer the right – but not the obligation – to purchase shares of an underlying asset you own at a set price within a specific timeframe.
Who Typically Uses Covered Calls
Covered calls are typically used to earn income generated from selling the call option. Ideally, the option expires worthless and the seller keeps the premium and their shares. Most brokerages allow individual investors to sell covered calls, but you’ll need approval for options trading first and you must own enough shares, typically 100 per contract, of the underlying asset.
Mechanics of a Covered Call
There are several components to covered calls:
Owning the Underlying Asset
Before you can sell a covered call, you must own the underlying asset, typically 100 shares per contract. Think of these shares as collateral for the call option you sell.
Selling Call Options
When you sell a call option, the buyer pays a premium for the right, but not the obligation, to purchase the asset from you at a set price (the strike price) before a set date (called the expiration date). The premium paid by the buyer is yours to keep, regardless of whether the option is exercised.
Exercise, Assignment and Expiration Outcomes
“Exercise” occurs when the option buyer chooses to use their right to buy the stock at the strike price. When this happens, the seller is “assigned,” meaning they are obligated to sell their shares at that price. These events can occur at any time before the option’s expiration.
“Expiration” refers to the date the options contract ends. At this point, a few things can happen:
- If the share price is below the strike price, the option expires worthless, and you keep the shares.
- If the share price rises above the strike price, the buyer is likely to exercise their option, but they aren’t required to. If the buyer exercises the option, which they can do before the expiration date, you must sell your shares at the strike price. You still keep the premium regardless of what the buyer decides.
Example of a Covered Call Trade
Say you own 100 shares of company XYZ Inc., which is trading at $20 per share. You believe the stock will rise over time, but expect it to stay flat in the near term. You want to generate some income on that stock, so you sell a call option that expires in one month with a strike price of $25 at a $2 premium.
After you sell the option, you immediately collect $200 (100 shares x $2 premium).
If the stock stays below $25 until the expiration date, you keep the shares and the $200 premium.
If the stock rises above $25 before expiration, and the buyer exercises the option, you must sell your shares at $25 – even if shares are trading at a higher price at the time. You will keep the $200 premium and receive $2,500 from the proceeds of the sale.
Risk and Return Profile of Covered Calls
Sources of Return: Premium, Dividends, and Price Movement
Income comes from the premiums generated by selling call options on stocks you already own. You’ll also continue to collect any dividends paid out by those holdings, until the buyer exercises the option and takes ownership of the stock. If that happens, you’ll also receive proceeds from the sale of the stock.
Downside Risks and Drawdowns
If the stock falls, the premium you received does help offset some of the decline, but that protection is limited. Beyond the premium received your risk is tied to how much you initially paid for the stock.
Partial Downside Cushion
Premiums earned on covered calls can provide a buffer against a loss, but only to a point. Suppose you bought a stock at $50 per share and you sell a covered call at a $4 premium. If the stock drops to $30, your loss is offset by the premium, meaning you only lose $16 per share instead of $20.
Upside Cap and Opportunity Cost
One risk is the stock rising higher than you expected. If the stock price surges above your strike price, and you call is assigned, you are missing out on the rally because your shares will be sold at the strike price.
Strategic Uses of Covered Calls
Here are some ways you can use covered calls strategically in your portfolio.
Income Generation
You might deploy this strategy if you need additional income and have no immediate plans to sell a stock.
Enhancing Returns
Covered calls can enhance returns by effectively lowering the cost basis of a stock position.
For example, say you buy a stock at $50 per share. You then sell a call for a $3 premium, making your effective cost basis $47. The stock is later sold at $60, meaning you’ve made $13 per share rather than $10 had you not sold the call option.
Tax Considerations
In Canada, premiums are generally treated as capital gains when the option expires or is closed out. This means 50% of the profits on that premium is added to your taxable income for the year. If the covered call is executed in a Tax-Free Savings Account (TFSA), the premiums earned are generally tax-free. An accountant or financial advisor can help you understand the full tax implications of covered calls.