Yes, you generally must own at least 100 shares of the underlying stock for every one standard call option contract you sell to create a "covered" call. Because one standard option contract represents 100 shares, you need that position to deliver the shares if the option is assigned (exercised) by the buyer.
A covered call is a basic options strategy that involves selling a call option (or “going short,” as the pros call it) for every 100 shares of the underlying stock that you own. It's a relatively simple options trade to set up, and it generates some income from a stock position.
Mechanics of a Covered Call. Executing a covered call requires you to own at least 100 shares of the underlying stock. The process begins by writing (selling) call options on the same asset they hold. The aim is to collect premium income while potentially capping the upside gains of the stock as a covered call writer.
If the call is ITM—below the stock's current price—on or before expiration, the likelihood that the option buyer will exercise their right to buy the underlying at the strike price increases. If this happens, the covered call seller is required to deliver the stock—100 shares for each options contract sold.
With stocks, each put contract represents 100 shares of the underlying security. Investors do not need to own the underlying asset for them to purchase or sell puts. The buyer of the put has the right, but not the obligation, to sell the asset at a specified price, within a specified time frame.
A naked call option is when an option seller sells a call option without owning the underlying stock. Naked short selling of options is considered very risky since there is no limit to how high a stock's price can go and the option seller is not “covered” against potential losses by owning the underlying stock.
The 7% sell rule is a stock trading guideline to cut losses quickly, advising you to sell a stock if it drops 7-8% below your purchase price to protect capital, remove emotion, and prevent small losses from becoming catastrophic, a strategy popularized by William O'Neil's CAN SLIM method for growth investing. It assumes that truly strong stocks typically don't fall much below their buy point, so a dip signals something is wrong, requiring you to exit the trade to preserve funds for better opportunities.
Tips on how to sell covered calls
In most cases, stock options contracts are for 100 shares of the underlying stock. You can have one contract or many, but fractional contracts are not traded. An option contract is defined by the following elements: Type (Put or Call)
The 3-5-7 rule in trading is a risk management guideline: risk no more than 3% of capital on one trade, keep total risk across all trades under 5%, and aim for winning trades to be at least 7% larger than losing trades (or a 7:1 ratio) to ensure profits outweigh losses and protect capital. It promotes discipline, reduces emotional trading, and balances potential high rewards with controlled risk, making it great for beginners.
The sweet spot for this strategy depends on your objective. If you are selling covered calls to earn income on your stock, then you want the stock to remain as close to the strike price as possible without going above it.
If you're going forward with a covered call though, you do need to own the shares, and must own at least 100 shares. Owning the security (that's why it's called “covered”), such as shares of a company or an exchange traded fund (ETF), is the first step in a covered call.
Covered calls aren't inherently bad for stocks, but they can limit potential upside. If the stock price rises sharply, gains are capped at the strike price of the call sold. This strategy sacrifices growth in exchange for short-term income, which may not align with long-term investment goals.
Losses occur in covered calls if the stock price declines below the breakeven point. There is also an opportunity risk if the stock price rises above the effective selling price of the covered call.
A covered call requires ownership of at least 100 shares of stock. If the stock is already owned, a call option may be sold at a higher strike price than the current stock price. A covered call can also be sold at the time the long stock is purchased.
According to Taxes and Investing, the money received from selling a covered call is not included in income at the time the call is sold. Income or loss is recognized when the call is closed either by expiring worthless, by being closed with a closing purchase transaction, or by being assigned.
In this iteration of the covered call strategy, instead of buying 100 shares of stock and then selling a call option, the trader simply purchases a longer dated (and typically lower strike price) call option in place of the stock position and buys more options than he sells.
Each options contract controls 100 shares of the underlying stock. Buying three call options contracts, for example, grants the owner the right, but not the obligation, to buy 300 shares (3 x 100 = 300).
Yes, Warren Buffett does sell covered calls, often as part of a strategy to generate income or facilitate selling positions, though he's more famous for selling cash-secured puts to buy stocks he wants at lower prices, effectively using options to enhance returns and manage his cash flow. He collects premium from selling covered calls on stocks he already owns, giving up some upside potential in exchange for immediate income, and if the stock price rises, his shares get called away at the strike price, increasing his cash.
Here's a good time to sell a covered call: when you can already calculate at what price your shares would be overvalued. Rather than waiting for shares to become overvalued, and then sitting around deciding whether or not you should sell them, you can plan this in advance.
A capital gains rate of 0% applies if your taxable income is less than or equal to: $48,350 for single and married filing separately; $96,700 for married filing jointly and qualifying surviving spouse; and. $64,750 for head of household.