Seasoned investors sometimes use covered calls for a few things. A covered call strategy can add income to your portfolio by collecting premiums from an option. Additionally, an investor can potentially lock in a sale price for a portfolio stock holding.

If you’re considering covered calls for your portfolio, make sure you know exactly how it works. Covered calls are a bit more complex than just buying or selling stocks. The strategy includes options on stocks that you already own.

In addition to the benefits mentioned above, a covered call strategy has risks. Let’s start with the basics.

What is an Option?

Covered calls involve selling call option where the underlying stock is in your portfolio. A call option gives the buyer the option, but not the obligation, to buy your stock at a predetermined price (strike price) on or before a predetermined date (expiration date).

The strike price and expiration are standardized in the call option contract. The strike price can be above or below the underlying stock’s current price. The expiration date is typically a few days to a few months. Remember, call options contracts are for 100 shares of the underlying stock.

The price an option buyer pays for the options contract is called the premium.

Keep reading for more info on covered calls.

Call Option Example

Say Apple (Nasdaq: AAPL) is currently trading at $160 per share. A call option for Apple stock with a strike price of $170, which expires in 20 days, could be bought or sold for a $2 premium. The seller would immediately collect a $200 ($2 x 100) premium from the buyer. If 20 days pass and Apple stock does not go above $170, the call option expires worthless to the buyer. In this case, the seller simply profits the $200 premium.

On the other hand, let’s say the stock goes up to $180 per share before expiration. The seller has still collected the $200 premium. Now the buyer can choose to take 100 shares of Apple stock from the seller (worth $180 per share) or settle the contract in cash. If the buyer chooses to settle in cash (usually the case), the seller owes the buyer the difference between the current price and the strike price. In this case, $1,000 ($180-$170 x 100). On a net basis, the seller loses $800 ($1,000 loss on the call option, $200 premium).

Selling Covered Calls for Income

In a covered call strategy, you are the seller of options contracts on stocks you already own. Keeping with the example above, let’s say you own 1,000 shares of Apple stock. You also want to implement a covered call strategy to generate income from collecting call option premiums.

In a covered call transaction, you can sell 100 call options to cover your 1,000 shares. If you intend to keep your shares, you might want to sell a call option with a strike price that is well above the current $160 share price. Say $200. In this case, the call option premium will be much lower because there is a lower chance that the stock will reach $200 than $180 within the next 20 days.

The premium for a $200 strike call option may be closer to $.05 or $50 per contract.

Selling Covered Calls to Sell Your Stock

Let’s say that you believe your Apple stock is worth $200 per share. In this case, you could sell call options with a $200 strike price and collect the premium. If the stock advances above $200 per share, you can sell your stock at a great price to cover the cash settlement or deliver your shares to the buyer (the buyer chooses cash or delivery).

In addition to selling your shares at a great price, you’ve collected the call option premium.

How to Sell Covered Calls

Remember, options contracts are based on 100 shares of the underlying stock. Whether your goal is to generate income or lock in a selling price, the amount is the same.

If you want to implement a covered call strategy on your 1,000 shares of Apple, you’ll need to sell ten contracts.

Risks of a Covered Call Strategy

A covered call strategy is less risky than selling a call option without owning the underlying stock (naked call option). In a naked call option contract, the stock could rise dramatically above the strike price before the expiration. In a naked call option, your potential loss is theoretically infinite.

Owning the underlying stock mitigates massive losses from the call option contract if the stock skyrockets. In that case, your portfolio would’ve been much better off by just owning the skyrocketing stock.

Covered call investors may be tempted to sell call options of their favorite stocks at a lower stock price. Though you would collect a higher premium, the risk of losing your favorite stock is more elevated. If you give in to temptation, there is a chance you could lose your favorite long-term holding.

Any covered call strategy involves the risk of selling your stock. Make sure you keep an eye on taxes. If you’re forced to sell a stock with significant embedded gains, you could also be stuck with a tax bill at the end of the year.