For example, an investor holding 500 shares of XYZ @ $50 can sell 5 $55 strike call options against it. Selling calls against shares you own enables investors to generate income on their stock holdings, but investors are obligated to sell their shares if their short call options are assigned early or if it expires ITM. Selling call(s) against round lots of stock to form a covered call position is allowed in margin and cash accounts.
Since each long call gives the buyer a right to buy 100 shares of stock at the option's strike price, a call option seller must sell the stock at the option's strike price if the long holder exercises early or if it expires in the money (ITM) by $0.01 or more at expiration. In short, options buyers buy a right, and sellers are obligated to sell a hundred shares per contract at the option's strike when the long holder exercises or if it expires ITM.
Assuming the call option sold against the stock position remains OTM during the life of the trade, the value of the call option sold may erode each day due to time decay and potentially be closed (purchased back) below the selling price to yield a profit. A call option that expires OTM at expiration will be worthless and generate a max profit. The profit from the covered call positions helps generate interim income for investors holding a long stock position.
A covered call gets its name since the long stock collateralizes the short call. A covered call is collateralized since an investor with only a short call in their portfolio would have 100 short shares if the option were assigned. The long shares collateralize the short call resulting in the account being flat (no shares) and preventing it from being short 100 shares. Whereas a naked short call (uncovered) would have potentially unlimited risk since a stock can theoretically rise without limit.
There is always the risk of the stock falling and losing value, which could help yield a profit on the covered call, but the gain made on the covered call may not cover the value lost on the shares.
Additionally, covered calls sold at a strike below the share's cost basis (average cost per share) could result in locked-in losses if the shares get called away (or sold) early by assignment. For example, if you purchased 100 XYZ @ $50, but it is currently trading at $30, then selling a $40-strike call against the shares could lock in a $10 loss per share (-$1,000 total loss excluding the income from the call options) if the shares were called away early or if XYZ closed above $40 at expiration.
Lastly, for dividend-paying stocks, covered calls also risk dividend forfeiture if the shares get called away before the ex-dividend date. Learn more in the Help Center.
Profit & Loss Diagram of a Covered Call
The profit and loss diagram below assumes a covered call sold above the stock's cost basis. Since investors with a covered call position are selling their upside, an investor's max profit will cap if the underlying surpasses the covered call's strike price, as illustrated where the green profit zone flattens. Investors with a covered call position also face the risk of the value of their stock position falling. Although a falling stock price will favor a covered call position by depreciating the short call, the potential profit on the call may not cover the value lost on the shares.