How to Use Options for Income: A Beginner’s Guide to Covered Calls
Ever felt like you’re just leaving money on the table with your investments? You’ve bought some great stocks, they’re doing okay, but you wish there was a way to squeeze a little extra income out of them. Like a bonus dividend, almost.
Well, guess what? There kinda is, and it’s called a covered call. This strategy can turn your existing stock holdings into a little income stream, and it’s not nearly as complicated as it sounds. We’re talking about making your investments work harder for you.
What This Actually Means for Your Wallet
Think of a covered call as renting out your shares for a short period. You own a stock, say 100 shares of Company X, and you're pretty happy holding onto it for the long run. Someone else might be willing to pay you a small fee today for the right to buy your shares at a set price in the future.
If they don't buy, you keep the fee and your shares. If they do, you sell your shares at a profit (hopefully) and still keep that initial fee. That fee is your income, and it hits your account almost immediately.
For instance, say you own 100 shares of a stock trading at $50. You could sell a covered call that expires next month, giving someone the right to buy your shares for $52. If you get paid $1.50 per share for that right, you’ve just pocketed $150 (100 shares x $1.50) without selling anything yet.
Let's Get Real: What Are Covered Calls?
At its heart, a covered call is just a financial contract. It gives the buyer the option to purchase 100 shares of a specific stock from you at a predetermined price, called the strike price, before a certain date, the expiration date. You, the seller, are "covered" because you already own the shares.
You get paid a non-refundable fee upfront for taking on this obligation. This fee, known as the premium, is the income you generate from selling the call. It’s deposited into your brokerage account right after you make the trade.
How It Works in Practice
Let's walk through a common scenario to make this super clear. Imagine you bought 100 shares of ACME Corp (ticker: ACME) a while ago, and you paid $40 per share. Today, ACME is trading at $50 per share. You like the company, but you're okay if it gets called away at a higher price.
You decide to sell one covered call contract. Each contract covers 100 shares, so you need to own at least 100 shares to sell one. You look at the options chain and see you can sell a call option with a $52 strike price that expires 30 days from now, and it’s paying a premium of $1.75 per share.
So, you place an order to sell one ACME $52-strike 30-day call option. As soon as the trade executes, $175 (100 shares x $1.75) lands in your account. That’s your instant income, no matter what happens next.
Here’s a quick breakdown of what just happened:
You own the stock (you're "covered"): You already held 100 shares of ACME that you bought at $40, now trading at $50. This is crucial; you can't sell covered calls if you don't own the underlying stock. It's like trying to rent out a house you don't actually own. You sold the call option (your obligation): By selling the call, you’ve given someone else the right to buy your 100 shares of ACME for $52 per share. This right only lasts until the option's expiration date. You hope the stock stays below $52, so you keep your shares and the premium. You collected the premium (your income): You instantly received $175 for making this agreement. This money is yours to keep, regardless of whether the option is exercised or not. It’s pure profit on top of any potential gains from the stock's appreciation up to the strike price.Now, let's fast forward to that expiration date. Two main things could happen with your ACME covered call. First, if ACME stock stays below $52 per share, the option expires worthless. The buyer won't exercise their right to buy at $52 when they can just buy it cheaper on the open market.
In this best-case scenario, you keep your $175 premium, and you still own your original 100 shares of ACME. You're free to sell another covered call for the next month, generating more income. Pretty sweet, right?
Second, if ACME stock jumps above $52 per share by expiration, the buyer will likely exercise their option. This means your shares will be "called away" from you. You’ll sell your 100 shares of ACME at the $52 strike price, even if the stock is trading higher, say at $55.
You still keep the $175 premium you collected. Plus, you've made a capital gain from your original purchase price of $40 up to the $52 strike price, which is $12 per share or $1,200 total. So, your total profit from this single cycle would be $1,200 (stock gain) + $175 (premium) = $1,375. You gave up some potential upside above $52, but you got paid for doing it.
Ready to Dive In? Your First Steps to Covered Call Income
Alright, feeling a little less intimidated? Good. Now, if you’re thinking about trying this, here are some practical steps to get you started. Remember, we’re keeping it simple and beginner-friendly here.
Step 1: Understand What You Own (And Why)
Before you even think about selling a covered call, you need to already own at least 100 shares of a stock. Don't go buying 100 shares just to sell a call unless you truly believe in the company for the long haul. This strategy works best on stocks you'd be happy to hold even if they don't get "called away."
Think about stocks in your portfolio that you’re comfortable holding long-term. Look for companies with decent stability, not super volatile penny stocks. You want to avoid big, sudden drops that would make you regret tying up your shares.
Step 2: Pick Your Strike Price and Expiration Date
This is where you make some decisions. You’ll typically want to choose a strike price that’s above the current stock price. This is called an "out-of-the-money" call, and it gives you some room for the stock to grow before your shares might get called away. If you pick a strike price that's too low, you risk your shares being called away very quickly.
Next, choose an expiration date. Beginners often start with shorter expirations, like 30 to 45 days out. This keeps your capital tied up for less time and allows you to collect premiums more frequently if the option expires worthless. Longer expirations usually pay more premium, but they also tie up your shares for longer and introduce more risk of large stock movements.
Step 3: Place Your Trade (Carefully!)
Once you’ve got your stock, your chosen strike price, and an expiration date, it’s time to go to your brokerage platform. Look for the "options chain" for your specific stock. You'll want to select "Sell to Open" (not "Buy to Open") for the call option.
Double-check your order details: the symbol, the strike price, the expiration date, and that you’re selling
one contract (if you have 100 shares). Then, you'll enter the price you want to receive for the premium – usually, you’ll see "bid" and "ask" prices, and you can aim for somewhere in the middle for a quick fill. Once filled, that premium hits your account!Show Me the Money: A Real-World Covered Call Example
Let’s dig into a more detailed example with actual numbers to illustrate the potential income. Say you own 200 shares of a tech company, "InnovateCo" (ticker: INVT). You bought them at an average price of $80 per share, so your total investment is $16,000. Today, INVT is trading at $95 per share.
You decide to sell two covered call contracts (since each contract covers 100 shares, and you have 200 shares). You look at the options chain and choose a strike price of $100, expiring 45 days from now. The premium for this specific option is $2.50 per share.
When you sell these two contracts, you immediately receive $500 into your account (2 contracts x 100 shares/contract x $2.50/share). That's your instant, upfront income.
Now, let's look at the possible outcomes at the end of the 45 days:
Scenario A: INVT stays below $100 (e.g., it closes at $98)The call options expire worthless. The buyer won't pay $100 per share when they can buy INVT for $98 on the open market.
The call options are exercised. Your 200 shares of INVT are "called away" from you at the $100 strike price.
You keep your $500 premium. You sell your 200 shares for $100 each, totaling $20,000. Your original cost was $80 per share ($16,000 total). Your capital gain from the stock is $20,000 - $16,000 = $4,000. Your total profit from this cycle is $4,000 (stock gain) + $500 (premium) = $4,500.You limited your upside to $100 (missing out on the rise to $105), but you got paid extra for that. It’s like selling your car with a good profit, plus getting a bonus for agreeing to sell it at that price.
This example shows how covered calls can boost your returns, whether the stock moves up, stays flat, or even drops slightly (as long as it stays above your effective cost basis and the premium covers any small loss). It’s about consistently generating small sums, which can really add up over time.
Quick math: If you invest $300/month at 8% for 10 years, you'll have roughly $54,000. That's $18,000 in pure gains. Consistently generating $100-$200 in premium each month can certainly accelerate your wealth accumulation.
Uh Oh: What Can Go Wrong (And How to Fix It)
While covered calls are generally considered one of the safer options strategies, they're not without their quirks. I've definitely learned a few lessons over my 15 years, so let's talk about what to watch out for.
Mistake #1: Your Stock Takes a Nosedive
This is the big one. You sell a covered call, collect your premium, and then the underlying stock you own absolutely craters. Say you sold a call on shares you bought at $50, and they suddenly drop to $35. You're still obligated to hold those shares until expiration, or buy back the call.
Your shares are now worth significantly less, and the small premium you collected ($100-$200) doesn't come close to offsetting the capital loss on your stock. You still own the depreciated shares, and you’re down quite a bit.
How to fix it: This emphasizes the "covered" part. Only sell covered calls on stocks you genuinely want to own for the long term. Do your homework. Choose stable, quality companies. If the stock tanks, you either hold through it (and sell more calls later if it recovers) or you take the loss and move on. Don't chase high premiums on super volatile stocks you wouldn't otherwise touch.Mistake #2: Your Stock Rockets Past the Strike Price
This is often called "opportunity cost." Imagine you sold a covered call with a $60 strike price on a stock currently trading at $58. You get a nice premium. Then, the company announces some amazing news, and the stock explodes to $75.
Your shares will be called away at $60. You've capped your profit at $60 (plus the premium), missing out on the extra $15 per share gain that you could have made if you hadn't sold the call. It feels a bit like you left money on the table.
How to fix it: Accept that this is part of the covered call strategy. You're giving up some unlimited upside potential in exchange for consistent, upfront income. If you think a stock is about to make a huge move, maybe don't sell a covered call on it. You can also choose higher strike prices (further out-of-the-money) to give your stock more room to run, though you'll collect less premium. It's a trade-off.Mistake #3: Choosing the Wrong Strike Price or Expiration
Picking a strike price too close to the current stock price (called "in-the-money" or "at-the-money") means your shares are much more likely to be called away, limiting your capital gains significantly. Picking one too far out could mean a tiny premium that barely justifies the effort.
Similarly, an expiration date that’s too short might not give the premium enough time value to be worth much. Too long, and you're tying up your shares for a while, making them unavailable for other strategies or trades if you change your mind.
How to fix it: Practice and research! Start with out-of-the-money strikes, giving yourself a buffer. For expiration, most beginners stick to 30-45 days. This balance often offers decent premium without overly long commitments. Experiment with a small amount of capital and track your results. What feels right for your goals?Mistake #4: Not Understanding Assignment
When your shares are "called away," it's called "assignment." This usually happens automatically by your broker on the expiration date if the stock closes above your strike price. The biggest mistake is being surprised by it.
If you weren't prepared for your shares to be sold, you might be upset you missed out on future gains or that your portfolio composition has changed. Sometimes people sell a covered call, then decide they
really don't want to sell the stock at the strike price. How to fix it: Go into every covered call trade with the mindset that your shares might be called away. If you absolutely, positively do not want to sell your shares at the strike price, then do not sell the covered call. If the stock price approaches your strike and you decide you want to keep your shares, you can always buy back the call option to close out your obligation. This will cost money, potentially eating into or exceeding your initial premium, but it keeps your shares.Your Burning Questions, Answered
I know this is a lot to take in, so let’s hit some of the common questions folks ask when they first learn about covered calls. Don't worry, we're doing this over a virtual coffee, so no silly questions allowed!
Is this right for beginners?
Absolutely, I think covered calls are one of the best "entry-level" options strategies. They're much simpler than many other options plays because you already own the underlying asset. You don't have to guess if a stock will go up or down to profit, just how much it
might move.You’re essentially adding a layer of income to stocks you already own and like. It's a relatively conservative strategy, especially when compared to just buying naked calls or puts, which have unlimited risk. For generating extra cash flow from your portfolio, it's a solid choice.
How much money do I need to start?
This really depends on the price of the stock you want to trade. Since each covered call contract represents 100 shares, you need enough capital to buy 100 shares of your chosen stock. For example, if you want to sell covered calls on a stock trading at $50 per share, you'd need $5,000 (100 shares x $50).
There are plenty of great companies that trade below $50, so it’s definitely accessible. You can start with a single contract on a lower-priced stock to get the hang of it. You'll also need a brokerage account that's approved for options trading, which usually means filling out a short questionnaire.
What are the main risks?
The biggest risk, as we talked about, is that your underlying stock drops significantly. While you keep the premium, the capital loss on your shares could far outweigh that premium. Your shares could also be called away at a price lower than what they eventually climb to, limiting your upside.
Essentially, you're trading unlimited upside potential for consistent, limited income. There's also the risk that you pick an illiquid option (one that doesn't trade much), making it hard to get a good price for your premium or to close your position if you need to. Always stick to well-known stocks with active options markets.
How does this compare to just buying and holding?
Buying and holding is fantastic, and it's the bedrock of long-term investing. Covered calls complement buying and holding; they don't replace it. With covered calls, you're essentially getting paid extra to hold your shares.
If your stock trades flat or only goes up a little, the covered call premium boosts your return beyond what you'd get from just holding. However, if your stock absolutely explodes, a covered call will limit your participation in that massive upside. It's a balance: less pure upside, more consistent income.
Can I lose all my money?
No, you can't lose
all your money with a covered call in the same way you could with a leveraged or speculative options strategy. Your maximum potential loss is the loss in value of the underlying shares that you own. If you buy a stock for $100 and it goes to $0, you lose $100 per share, minus any premium you collected.The premium you receive from selling the call actually
reduces your effective cost basis. So, if you bought a stock at $50 and collected a $2 premium, your effective cost is now $48. This provides a small buffer against a downturn. The strategy is designed to be relatively conservative because* you own the underlying asset.How often can I sell calls?
You can sell covered calls as often as you want, as long as you own the underlying shares. If you sell a 30-day covered call and it expires worthless, you can turn right around and sell another one the very next trading day. This is how many investors generate consistent monthly or weekly income.
It becomes a cycle: sell a call, collect premium, wait for expiration. If it expires, sell another. If your shares are called away, you then have cash to potentially buy back into the stock or find a new opportunity. Just remember to always maintain that 100 shares per contract.
The Bottom Line
Covered calls are a fantastic way to generate extra income from stocks you already own and plan to hold. They offer a relatively low-risk entry into the world of options, giving you a tangible cash boost straight into your account.
Start small, pick stable stocks you love, and don’t be afraid to try this out. You might just find a new favorite strategy for making your money work smarter.
Comments (0)
No comments yet. Be the first to share your thoughts!
Leave a Comment