A covered call is a strategy that combines a long-term stock position with a short-term call option. The investor in this strategy owns a particular asset, such as a stock, and then they sell (write) a call option with a specific expiration date, an exercise price of the option, and a strike price. The buyer of the call option has the right, but not the obligation, to purchase the asset at the specified price from the option seller. Thus, the investor executing a covered call has the obligation to sell the asset if the buyer exercises their option.

For a covered call strategy to work, the expectation is that the stock will not exceed the strike price of the covered call option. Ideally, the stock will remain at or below the strike price, though it can find itself somewhere in the middle of that range. When the stock stays at or below the strike price, the investor will be able to keep the option premium paid by the buyer of the covered call option. Additionally, the investor will still own the underlying asset should the buyer of the call option not exercise their right to buy it before the expiration date.

The main advantage to the covered call strategy is that it enables the investor to earn a steady and consistent income stream as long as the stock does not exceed the strike price. The investor can often turn this portion of their portfolio into a source of income. Additionally, the covered call position can help protect the investor against a decrease in the price of the underlying asset, thus making the strategy attractive to conservative investors.

On the downside, the covered call does not allow for much growth on the underlying asset. If the underlying asset does gain in value and exceeds the strike price, then the investor will miss out on the additional profits from the increase as they have already sold call options and secured the income from the option premium. Thus, the covered call is best used when the investor intends to keep the underlying asset in the same price range, as any significant increase in price will result in the option being exercised and the underlying asset being sold away.

Covered calls are often utilized by investors who intend to hold the underlying asset for a long time, such as dividend investors and income investors, as the income generated from the option is seen as a tool for mitigating the potential for loss and maximizing capital efficiency. The covered call strategy is also marketed as a way to hedge an investor’s portfolio, protect the downside, or squeeze extra profits from a sideways market. Ultimately, the covered call is best used when you expect little to no movement in the underlying asset, as any large gain or loss in the price of the asset will benefit or detriment the investor depending on the direction of the movement and the strike price of the option.