What it is
You own 100 shares and sell one call against them. In return for a premium paid to you now, the buyer gets the right to take your shares at the strike before the contract ends. If the stock finishes below the strike, the call expires and you keep the shares and the premium. If it finishes above, your shares are sold at the strike and you keep the premium.
"Covered" means the shares are already in the account. That is what makes the call's worst case a missed rally rather than an open-ended loss: whatever price the stock reaches, you hand over shares you own instead of buying them in the market to deliver.
What has to happen for it to make money
The shares have to finish above the break-even: the price the shares were bought at, less the premium. Up to the strike, every dollar the stock rises is yours as well as the premium. Past the strike the position is full, and the rest of the rally belongs to whoever bought the call.
The market it suits best is a slow drift upward or a stock going nowhere. A fast rally is the expensive case, because it is the one where the call takes the most. A fall is the case the premium barely touches, because you still own every share.
Falling volatility helps while the call is open, for the same reason it helps any sold option: the call is cheaper to buy back. The shares do not care either way.
Once it is on
As expiry nears, the question is what to do if the stock is above the strike. Letting the shares go realises the gain up to the strike. Buying the call back and selling a later one, a roll, keeps the shares but costs the difference, and a roll that is repeated every month is still a series of separate decisions with separate costs. An upcoming dividend makes an early assignment more likely when the call is in the money, because the buyer wants the dividend.
Selling the shares at the strike can also realise a taxable gain in a year you did not plan to. That is a question about your own cost basis, and nothing here works it out for you.
What goes wrong
A fall. The premium is a small cushion against a loss on 100 shares, so a covered call loses nearly as much as the shares alone when the stock drops hard.
A rally you do not get. Over a long run the biggest gains in a stock or an index tend to arrive in a few sharp moves, and those are exactly what the call sells. This site measured it on thirty years of the S&P 500, and the covered call returned less than simply holding the index, with a somewhat shallower worst fall. That is a real trade-off, and it is not the free income the name suggests.
Pros and cons
- Pro: paid on shares you were going to hold anyway.
- Pro: no extra money at risk beyond the shares.
- Pro: a flat or slowly rising stock pays it in full.
- Con: the upside is capped at the strike.
- Con: almost none of the downside is removed.
- Con: assignment can sell shares, and realise a gain, on someone else's timing.
In Restrike
A covered call sits under the shares it is written against on the Portfolio, with its own break-even and what assignment would be worth. A call rolled into a later one is kept as one campaign, and the Log scores a covered call on what its cap cost rather than on premium kept. It can be imported read-only from your broker, since Restrike never places a trade, or typed in.