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Managing Covered Calls

Managing Covered Calls

Key Points
  • Covered calls are one of the most popular option strategies.

  • When your covered call is approaching expiration and is in the money, at the money, or out of the money, you need to know what your "options" are.

  • We will explore these potential next steps: don't act, close-out, unwind, rollout, rollout and up, and rollout and down.

I've written many articles and taught hundreds of seminars about the potential benefits of buy/writes and covered calls and I always emphasize the importance of having the proper expectations before establishing the position(s).

A covered call writer typically has a neutral to slightly bullish sentiment. However, you should generally sell covered calls only on positions that are equal to or above the price you originally paid for them. If you own a stock and it has declined sharply since purchasing it, covered calls are probably not the best choice for trying to recover some of your losses.

When establishing a covered call position, most investors sell options with a strike price that is at the money (ATM) or slightly out of the money (OOTM). If you select OOTM covered calls and the stock remains flat or declines in value, the options should eventually expire worthless and you'll get to keep the premium you received when they were sold, without further obligation. If you select ATM covered calls and the stock declines in value, they too should expire worthless and the outcome is essentially the same.

Profit and loss for a covered call

Image: Covered calls1

Source: Schwab Center for Financial Research.

However, sometimes the stock may end up very close to the strike price or it may go up in price and end up in the money (ITM). Then what do you do? Let's explore several possible actions:

  • Expiration: Do nothing and let your options expire worthless.
  • Assignment: Do nothing and let your stock be called away at or before expiration.
  • Close-out: Buy back the covered calls (at a gain or loss) and retain your stock.
  • Unwind: Buy back the covered calls (at a gain or loss) and simultaneously sell your stock.
  • Rollout: Buy back your covered calls and sell same strike covered calls for a later month.
  • Rollout and up: Buy back your covered calls and sell higher strike covered calls for a later month.
  • Rollout and down: Buy back your covered calls and sell lower strike covered calls for a later month.

Expiration
Sometimes if your stock position has remained relatively flat or even declined, your covered calls may be very OOTM as the expiration date approaches.

  • In this situation, the best course of action may be to let your OOTM options expire worthless.
  • When this occurs, the options are automatically removed from your account and the net credit from the original sale of the options is retained in the account without further obligation.
  • Then, if you are still neutral to moderately bullish you can sell the stock or sell more covered calls against it for a later month.

Sometimes as the expiration date approaches, your stock position may be very close to the strike price and you may have difficulty projecting whether or not you will be assigned.

  • If you are neutral to slightly bearish on the stock, or if you are willing to take the risk, you can simply do nothing. If the options are exactly ATM or OOTM, they will most likely expire worthless.
  • When this occurs, the options are automatically removed from your account and the net credit from the original sale of the options is retained in the account; you have no further obligation.
  • At this point, you can sell the stock or sell more covered calls against it for a later expiration date.
  • If the options expire ITM (even by only $0.01) and you are assigned, keep reading.

Assignment
When the expiration date of the option arrives, if the option is ITM and you do nothing, your stock will be called away at the strike price.

  • This could occur prior to or at expiration. If you have become neutral to slightly bearish on the stock, this may be the best course of action.
  • The first thing to know when you are assigned is that this may be a good thing. If you sold ATM or OOTM calls, this will result in a net profit overall. Unless your options are deep ITM that profit will usually exceed the one you would have earned if you had owned the stock outright. It is also the maximum profit that can be earned on a covered call trade.
  • When you are assigned, your option and stock positions are both automatically removed from your account and the net credit from the assignment will show up in your balances the next business day.

Sometimes option assignments will occur prior to expiration. While this is most common for dividend-paying stocks, it can occur on any stock.

Dividend-paying stocks

  • Option prices are not adjusted for normal quarterly dividends so a long call owner often has an economic incentive to exercise, usually on the day right before the stock goes ex-dividend.
  • This is most common when the call options are ITM and the dividend amount exceeds the remaining time value in the options.
  • While the time value is lost when an option is exercised, this incentive exists because the [strike] price the call owner will pay for the stock is the same before the ex-dividend date or after; but if he/she exercises prior to the ex-dividend date, he/she will be the owner of record when the next dividend is paid.
  • If you intend to sell covered calls on dividend-paying stocks, it is very important to be aware of the ex-dividend dates.
  • If you have dividend-paying stocks and you can't bear the thought of having them called away or losing your dividends, don't sell covered calls on them.
  • If you would prefer to avoid assignment, but are willing to take at least some risk that it might occur anyway, keep reading.

Close-out
If you have chosen to sell covered calls on a dividend-paying stock position and the options are ITM as the ex-dividend date approaches, you can sometimes avoid having your stock called away and losing your dividend, by buying back the covered calls before the ex-dividend date.

  • While doing so could result in either a gain or a loss on the options, price appreciation on the stock position will usually offset any loss that might be incurred on the options, and you will remain owner of record for the next dividend payment.
  • Keep in mind that as a call seller (writer) you have assumed an obligation to sell your stock any time the call owner chooses.
  • While early assignments are most common on the day right before the ex-dividend date, they can occur any time your covered calls are ITM, so there is no guarantee that you will always be able to buy them back first.

As noted, while early assignments are most common on dividend-paying stocks, it can also occur on stocks that do not pay dividends.

  • For non-dividend paying stocks, early assignments most often occur within the last few days prior to the option's expiration. 
  • This may also be a good thing, because it results in maximum profit, and it happens a few days early.
  • While it is difficult to know if an early assignment will occur on a non-dividend paying stock, this is a risk you must be willing to assume when selling any covered calls.

Unwind
If you have chosen to sell covered calls on a stock that subsequently experiences a significant price increase exceeding your original expectations, you may want to consider exiting the entire position prior to expiration to lock in most of the gains early. One way to do this is to use a strategy known as an unwind, which closes out both legs of the position (stock and option) in a single transaction.

This can be done whether your covered call position was established as a buy/write (simultaneous purchase of stock and sale of options) or as an over/write (sale of options on stock already owned in the account).

Because an option has delta—an approximation of how much the option price changes relative to the stock price change—the net benefit from a stock price increase nearly always exceeds the net detriment of the related price increase in the option. Therefore, if the stock price was at least equal to the price you originally paid for it when you sold your covered calls, a sharper than expected price increase usually results in a net profit overall, when you choose to unwind the position.

When you unwind a covered call position early, you can lock in a gain sooner, but it will almost always be less than the maximum gain you could earn if you wait until expiration and the stock expires ITM. However, you may still choose to unwind the position because you will capture much of the gain early (sometimes several weeks early) but you can sometimes avoid the risk that an unexpected large rise might subsequently be followed by an equally unexpected fall of similar magnitude. In other words, holding out for a little more profit could cause an unrealized gain to become a realized loss.

The decision to unwind is often a difficult one to make so the calculation below may help you decide:

  • When the covered call position is established, divide the maximum possible gain (max profit) by the number of weeks until expiration, to determine the average expected gain per week.
  • When the sharp rise in price occurs, compare the potential profit from an unwind to the amount of time that has elapsed since the position was established, to see if the potential profit earned is ahead of schedule, on target or behind schedule.
  • If the profit is ahead, unwinding the positions may be most prudent.
  • If the profit is on target, maintaining or unwinding may be equally beneficial.
  • If the profit is behind, maintaining the positions may be most prudent.

Example
Assume you own 1,000 shares of BZZZ for which you paid a price of $72.85. You have decided to create a covered call by entering the following trade:

Sell 10 BZZZ Oct 75 Calls @ $1.50

Net proceeds = $1,500 (1.50 x 10 x 100)
Time until expiration = eight weeks
Breakeven = $71.35 (stock price - option premium)
Maximum loss = $71,350 (if the stock drops to zero)
Maximum gain = $3,650 (2.15 points on the stock + 1.50 points on the option x 10 x 100)
Average expected profit per week = $456.25 ($3,650 / 8)

Four weeks later BZZZ experiences a big price jump to $79 per share. By checking the quotes on the "unwind" screen of one of Schwab's trading platforms, you could close out the positions as follows:

Sell 1,000 BZZZ @ $79.00
Buy 10 BZZZ Oct 75 Calls @ -4.40
Net Credit 74.60

Potential profit = $3,250 (6.15 points on the stock - 2.90 points on the option x 10 x 100)
Original expected profit after four weeks = $1,825 ($456.25 x 4)

The potential profit from unwinding this position after four weeks exceeds the original expected profit ($3,250 vs. $1,825) so the most prudent course of action may be to unwind this covered call. Consider that 89% of the maximum gain has already been earned while only 50% of the time horizon has elapsed. Waiting four more weeks would only result in a maximum additional profit of $400 if BZZZ remains above $75.

Rollout
Sometimes as the expiration date approaches, your stock position may be very close to the strike price and you may have difficulty projecting whether you will be assigned or not. If you are neutral to slightly bearish, or if you are indifferent about being assigned, then do nothing and accept whatever happens.

If you believe the downside risk is fairly minimal at this point or if you would like to minimize the risk that you might be assigned soon, consider a rollout—the closing out of your existing covered calls for the current month, combined with a simultaneous sale of same strike covered calls for a later month. All of Schwab's trading platforms have a "rollout" screen designed for this purpose.

When your near-month option is very close to the money, a rollout to a later month can usually be entered at a net credit because the time value on an option with a later expiration will usually exceed the time value on a nearer option. This is especially true for options that are very close to the money, because they generally carry the greatest amount of time value.

However, if the option is deep ITM or way OOTM the difference in time values may be so small, that the spread between the bid and ask will cancel it out and the rollout cannot be done at a net credit. In this situation, a same strike rollout may not be the best course of action.

Example
Assume stock BAAA is currently trading at $73.15 and your July 57.50 calls are deep ITM. The August 57.50 call is priced slightly above the July contracts and they have $0.15 more time value. However, that difference is not enough to offset the $0.20 spread between the bid and ask prices.

In this example, an even strike rollout would require a $0.05 debit. It is not a prudent trade because it postpones the inevitable assignment for another month (most likely scenario) and it costs money to do so. In this situation, the best course of action may be to let the assignment occur and earn the maximum profit, or if you believe there is still more upside potential in the stock, just buy back the covered call to close the position.

Image: Covered calls2

Source: StreetSmart Edge.

In contrast, let's say stock BAAA is trading at $73.15 and your July 72.50 calls are slightly ITM. Because the 72.50 strike is only $0.65 ITM, it could be rolled out for a net credit of $0.75, which represents one month's worth of time value. An even strike rollout would postpone a likely assignment (for now), and generate an additional $75 cash per hundred shares (excluding commissions).

If your outlook on BAAA is mostly neutral, this might be a prudent trade; however, if your viewpoint on BAAA is still bullish, keep reading.

Image: Covered calls3

Source: StreetSmart Edge.

Rollout and up
Sometimes as the expiration date approaches, your stock position may be very close to the strike price and you may have difficulty projecting whether you will be assigned or not. If you're still bullish and you believe the stock has additional upside potential, consider a rollout and up—the closing out of your existing covered calls for the current month, combined with a simultaneous sale of higher strike covered calls for a later month. All of Schwab's trading platforms allow this type of trade to be done on the same "rollout" screen as an even strike rollout.

Stock BAAA is now trading at $73.15 and your July 72.50 covered calls are 0.65 ITM as expiration is approaching. Because you believe there is further upside potential in BAAA and you know that an even strike rollout has a maximum additional profit of only $75 per 100 shares, you may be willing to commit a small amount of additional capital to allow for an increase in additional profit potential.

In this example, you decide to close out the 72.50 calls for July and rollout and up to 75 calls for August. Your strike price increase is 2.50 but the additional time value is not quite enough to cover it so the net debit is 0.52. Therefore, this trade will cost you $52 per 100 shares, but it also allows BAAA to increase in price up to $75 per share before the maximum gain is reached. You have effectively increased your maximum gain potential by $1.98 (2.50 - 0.52) or $198 per 100 shares (not including commissions).

Image: Covered calls4

Source: StreetSmart Edge.

Before you execute a rollout and up, keep in mind that you are committing additional capital so you are raising the cost basis (and breakeven price) of this strategy. In other words, BAAA needs to increase by at least 0.52 over the next month for you to breakeven, so it's important for you to remain bullish on BAAA.

Rollout and down
In the example above, assume BAAA's price has already increased substantially since writing the July calls. Rather than staying bullish, you are now neutral. However, because the July options still have a lot of time value remaining, rather than unwind the position instead you'd like to lock in as much of the current profit as possible, and then wait until most of that time value has eroded away.

Sometimes stock price appreciation occurs well before expiration, but it doesn't go deep enough ITM to significantly reduce the time value on the options. One way to lock in a substantial portion of this type of gain without unwinding the position and having to forfeit the remaining time value is to rollout and down.

A rollout and down is the closing out of your existing covered calls for the current month, combined with a simultaneous sale of lower strike covered calls for a later month. All of Schwab's trading platforms allow this type of trade to be done on the same "rollout" screen as an even strike rollout. A rollout and down effectively swaps front month time value for second month intrinsic value.

Stock BAAA is now trading at $73.15 and your July 72.50 covered calls are 0.65 ITM but 30 days remain until expiration. As a result, the covered calls still have $1.39 (2.04 –  0.65) in time value remaining. You would like to lock in most of this profit, but if you unwind the position today, you will have to pay $1.39 in time value. If executed, this unwind would have a net closing credit of only $71.11 (73.15 – 2.04). You have decided to possibly wait awhile longer, especially if you could reduce the likelihood that a small pullback could wipe out most of those gains.

You choose to close out the 72.50 calls for July and rollout and down to 70 calls for August. You roll down $2.50 in strike. This trade is priced at a net credit of $2.11 so you receive a net credit of $211 per 100 shares now. While it effectively costs you $0.39 (2.11 – 2.50) to do so, you are protected down to $70. In other words, BAAA would have to drop below $70 by the August expiration for these calls to expire worthless; otherwise, your stock will be called away and sold at $70.

This results in an overall net credit of $72.11 (2.11 now and 70 later) versus $71.11 in the previous example. Therefore, waiting another month earns an additional $100 per 100 shares of stock as long as BAAA doesn't drop below $70.

Image: Covered calls5

Source: StreetSmart Edge.

Covered calls decision matrix

Image: Covered calls6

Source: Schwab Center for Financial Research.

What to keep in mind

  • Covered calls will usually constrain significant profit potential if a stock moves substantially in your favor.
  • Anytime you sell a covered call, you have established a maximum selling price for your stock. Any movement in the stock beyond that established price creates no additional profit for you.
  • It's rarely a good idea to sell a covered call if your stock position has already moved significantly against you. This could cause you to establish a closing price that ensures a loss to you.
  • To ensure that you do not lock in a losing trade, before you sell a covered call, always ask yourself, "Would I be happy if I had to sell my stock position at the strike price on this option?" If you can answer yes, you will probably be okay.
  • If your covered call is ITM, you could be assigned at any time.

This article provides a few examples of how to deal with a covered call position. You may find others but the key thing to remember is that no matter what happens, you do have "options." 

For additional information or for assistance with other options strategies, please contact a Schwab Trading Specialist at 800-435-9050.

I hope this enhanced your understanding of covered calls. I welcome your feedback—clicking on the thumbs up or thumbs down icons at the bottom of the page will allow you to contribute your thoughts. (If you are logged into Schwab.com, you can include comments in the Editor’s Feedback box.)

Next Steps

Talk to Us
To put these strategies to work in your portfolio:

  • Call Schwab anytime at 877-338-0192.
  • Talk to a Schwab Financial Consultant at your local branch.
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