Covered Call Strategy: A Reliable Way to Earn Steady Income from Your Stocks

As an investor, you may have wondered how to generate additional income while holding stocks. Apart from waiting for share prices to rise and collecting dividends, there’s actually another income strategy—the Covered Call. This options strategy allows investors to earn option premiums by selling call options while holding stocks, providing extra cash flow for their portfolios. This article will provide an in-depth explanation of how the Covered Call strategy works, how to put it into practice, and key risk management points to help you master this commonly used income-enhancing strategy in the market.

What Is the Covered Call Strategy

A Covered Call is an options trading strategy that combines holding stocks with selling call options. Specifically, when an investor owns a particular stock, they can sell a call option on that stock and immediately receive a premium. The strategy is called “covered” because the underlying shares “cover” the potential obligation from the call option sold.

Basic Structure of the Strategy

To use the Covered Call strategy, you need to meet two requirements: first, holding the underlying shares; and second, selling an equivalent number of call option contracts. Since each options contract typically represents 100 shares, you need to hold at least multiples of 100 shares to implement this strategy.

When you sell a call option, the buyer obtains the right to buy the stock from you at a set price (the strike price) by a designated date. In exchange, the seller (you) receives the premium up front. If the share price does not rise above the strike price by expiry, the option expires worthless, and the seller keeps both the shares and the premium.

Differences from Traditional Stock Holding

Traditional stock holding focuses mainly on capital appreciation and dividend income. In contrast, the Covered Call strategy adds a third source of income—the option premium.

How the Covered Call Strategy Works

Let’s illustrate how the Covered Call works in practice with an example.

Practical Example

Suppose an investor holds 100 shares of a tech company, currently trading at HKD 50. The investor has confidence in the company’s long-term outlook but expects its stock price to fluctuate within a range in the near term. In this situation, they consider executing a Covered Call strategy.

The investor sells one call option with a strike price of HKD 55 expiring in one month and collects a premium of HKD 2. That means an immediate income of HKD 200 (100 shares × HKD 2).

Three Possible Outcomes

At expiration, there are three possible scenarios:

Scenario 1: Stock price is below the strike price. If after a month the stock is still below HKD 55, the option buyer won’t exercise their right, and the option expires worthless. The investor keeps both the shares and the HKD 200 premium and may consider selling another Covered Call for the next month.

Scenario 2: Stock price is slightly above the strike price. If the stock rises to HKD 56, the option will be exercised and the buyer purchases the shares at HKD 55. The investor’s total profit is HKD 5 per share from price appreciation (HKD 55−HKD 50), plus a HKD 2 premium, totaling HKD 700.

Scenario 3: Stock price surges. If the shares jump to HKD 65, the investor must still sell the stock at HKD 55. Although they make a total gain of HKD 700, they forgo an extra HKD 10 of upside (HKD 65−HKD 55). This highlights the main limitation of Covered Calls—your upside potential is capped.

*The above example is for illustration only and does not constitute investment advice.

The Time Value of Option Premiums

Option premiums mainly consist of two parts: intrinsic value and time value. In Covered Call strategies, most investors choose out-of-the-money options (strike price above market price), so the premium is mainly from time value. As the expiry date approaches, the time value decays, which benefits the seller. Generally, it’s recommended to choose options with 30–45 days until expiration, as the rate of time decay is most favorable in this window.

Advantages and Risks of the Covered Call Strategy

Like any investment strategy, the Covered Call has both advantages and risks. Fully understanding these factors can help you make informed investment decisions.

Main Advantages

Generating additional cash flow is one of the main attractions of the Covered Call. The income from option premiums can be several times the stock’s dividend, and investors can continue to collect dividends. For instance, implementing the Covered Call strategy can significantly enhance your total return.

Reducing holding costs is another important benefit. Every premium you collect lowers your effective cost basis. For example, if you pay HKD 50 for the stock and receive a HKD 2 premium, your cost drops to HKD 48. This means you can break even even if the price falls to HKD 48.

Good in range-bound markets. When the market isn’t trending significantly, traditional holding strategies may struggle to deliver returns. However, Covered Calls let you continue to earn premiums even if the share price stagnates, producing a positive return.

Risks to Consider

Capped upside is the biggest limitation of Covered Calls. If the stock price surges far above the strike price, the investor only enjoys limited profit and misses out on further gains—a significant opportunity cost, especially for holders of high-growth stocks.

Downside risk remains. While the premium offers a small buffer, if the stock falls sharply, the investor will still incur losses. The premium can only offset a fraction of the loss. Thus, Covered Calls are not hedges—they are income enhancement tools.

Active management required. Compared to simple buy-and-hold, the Covered Call demands regular market monitoring, selection of suitable strike prices and expiries, and decisions on rolling the position, all of which require time and effort.

Choosing the Right Stocks and Option Contracts

The key to successful execution of the Covered Call strategy lies in selecting the appropriate stocks and option contracts. Here are some practical criteria to consider.

Characteristics of Ideal Stocks

Financially stable stocks are more suitable for Covered Calls. Shares with moderate volatility, solid financial fundamentals, and strong long-term prospects are popular choices for selling call options.

A liquid options market is also vital. Investors should ensure the stock’s options are actively traded with tight bid-ask spreads, so trades execute at fair prices.

Moderate volatility is best. If volatility is too low, premiums are small; if too high, stock prices can swing wildly, increasing the risk of assignment or significant declines.

Considerations in Choosing the Strike Price

The strike price you choose directly affects your risk and return profile. Out-of-the-money options (with strike prices above the current share price) are most common, allowing you to collect premiums while retaining some upside. A typical approach is to choose strike prices 5–10% above the current price.

Expiry Date Selection

Options with 30–45 days to expiry are a popular choice among traders. This time frame offers solid premium income with the fastest time decay. If the expiry is too short (one to two weeks), premiums are modest; for longer expiries (over three months), you earn more premium but lose flexibility and time decay is slower.

Frequently Asked Questions

What Type of Investor Is the Covered Call Strategy Best Suited For?

The Covered Call strategy is most suitable for investors who already own stocks, are confident in their long-term prospects, but expect their prices to remain range-bound in the short term. If you want to generate extra cash flow while holding shares and are willing to trade off some upside potential, this approach fits well. It is also a solid choice for retirees or those seeking steady income.

Can I Still Receive Dividends After Implementing a Covered Call?

Yes. As long as you hold the shares on the ex-dividend date, you’ll receive the dividend. Using a Covered Call doesn’t affect your dividend income. In fact, collecting both premiums and dividends yields dual income for investors. However, be aware an early option assignment is more likely right before the ex-dividend date.

What Should I Do If the Stock Price Plummets?

If the stock price declines significantly, the premium can only provide limited protection. You’ll need to assess whether to keep holding. If you maintain confidence in the long-term outlook, you can hold and sell another round of Covered Calls, accumulating premiums to lower your overall cost. If the fundamentals have deteriorated significantly, you may need to consider cutting your losses and exiting.

Is the Premium Income from Covered Calls Taxed?

The tax treatment depends on your country of residence and account type. In Hong Kong, individual investors’ profits from stocks and options are generally not taxed, but if the Inland Revenue Department deems you to be running a securities trading business, tax may apply. It’s best to consult a professional tax advisor about your circumstances.

Which Markets Can I Implement Covered Call Strategies In?

Longbridge Securities offers options trading on US stocks, where the market is more mature, highly liquid, and offers a broad choice of options.

Conclusion

The Covered Call is a practical options strategy that lets investors generate extra income while holding stocks. By selling call options and collecting premiums, you can enhance your portfolio’s return and reduce your cost basis, making it particularly suitable for sideways or mildly bullish markets.

That said, the strategy is not without its limitations. Investors must accept capped upside potential and endure the risk of share price declines. Success with Covered Calls depends on selecting the right stocks, strike prices, and expiries, as well as ongoing monitoring and position management.

Which investment tool you choose depends on your goals, risk tolerance, market outlook, and experience. Whichever you pick, make sure you fully understand its mechanics, risk characteristics, and trading rules, and put in place a solid risk management strategy. Learn more through the Longbridge Academy or by downloading the Longbridge App.