Covered calls: The silent strategy fueling top portfolios

Options are financial contracts that grant you the right to buy or sell an asset at a fixed price within a predetermined window of time. They come with various strategies to maximise gains or minimise losses. One standout is the covered call strategy.

What sets it apart? It’s one of the few options strategies that allows you to generate extra income from assets you already own while also offering some downside protection. Are you interested in learning how this dual benefit could revolutionise your investments?  Keep reading to find out more.

You may also like: How to trade in options and maximise your profit?

What is a covered call?

According to BSE, in an options strategy, a covered call is when you hold the underlying shares while selling a call option with the intention of receiving a call premium.

This strategy essentially allows you to lock in the stock’s price for a short period, offering a way to secure short-term profits. In exchange for selling this call option, you receive a premium, which serves as immediate income.

So what makes this different? Unlike selling a naked call option, which exposes you to significant risk if the stock price soars, a covered call mitigates this risk. Since you already own the underlying stock, your potential losses are limited, providing a layer of protection against adverse market moves.

When the call option expires, these outcomes are possible:

1. If the stock price closes above the strike price of the call, at that strike price, the call buyer will purchase your stock, but you keep the premium..
2. If the stock price finishes below the strike price, you retain both the stock and the option premium, and the call option expires worthless for the buyer.
3. If it doesn’t change, the premium you earned for selling the call option represents your profit. Whether or not the buyer decides to exercise the option, you’ll still pocket that premium and maintain ownership of your shares.

When to use covered calls?

This strategy is most effective in neutral to moderately bullish market conditions. Specifically, if you believe that the stock you own has limited upside potential in the near future, a covered call can be an excellent tool for booking short-term profits without selling the stock outright.

Covered calls work best in specific scenarios, but they aren’t suitable for all market conditions. If you expect significant price swings in your stock, this strategy might not be optimal.

In a volatile market, using covered calls could result in two pitfalls:

1. If the stock price soars beyond the strike price, you miss out on the additional gains.
2. Conversely, if the stock price plunges, you could face losses cushioned only by the initial premium received.

Also Read: Interest coverage ratio – A practical guide

Why use covered calls?

1. Additional income: You can generate extra earnings on the stock you already own.
2. Downside protection: In the event of minor stock price declines, the option premium can act as a cushion.
3. Sideways market strategy: Particularly useful when the stock price is not moving dramatically in either direction.

How to execute a covered call?

Exercising a covered call option doesn’t have to be difficult, however some analytical thinking is necessary.

Prerequisites

1. Own the stock: You need to have shares of a stock that you are willing to hold for the long term.
2. Understand the market: Be aware of the market conditions; this strategy works best in a sideways or slightly bullish market.

The process

Step 1: Choosing the strike price

Choose an appropriate strike price for selling the Call option. This has to exceed the stock’s current market price.

Step 2: Write the call option

You sell, or ‘write,’ a Call option against your stock at the strike price you’ve chosen.

Step 3: Receive the premium

The moment you write the call, you receive a premium. 

Step 4: Monitor and wait

Keep an eye on the stock price and the option’s expiration date. Depending on the closing price three scenarios can take place.

Step 5: Close or Roll Over

As the option’s expiration approaches, you have a couple of choices:

1. Close the position: Buy back the Call option to close the position.
2. Roll over: If you believe the stock will continue to move sideways or slightly upward, you can write another Call option with a new expiration date.

Also Read: Buy the dip, sell the rip – stock market strategy explained

Covered call example

An investor buys a stock at Rs. 900 and sells an Rs. 920 Call option, receiving a premium of Rs. 10. Let’s see how this would play out depending on the stock’s future price.

The table below provides an overview of what you stand to gain or lose at various stock price points:

(Source: IIFL Securities- Example recreated) 

Two specific cases:

1. Stock price at Rs. 870: When the stock price drops to Rs. 870, you’re looking at a Rs. 30 loss on the stock. However, you still get to keep the Rs. 10 premium from the sold call option. Your net loss? Rs. 20.
2. Stock price at Rs. 960: Should the stock shoot up to Rs. 960, you stand to gain Rs. 60 on your shares. But, you would lose Rs. 40 on the call option, netting out to the same Rs. 30 profit after accounting for the Rs. 10 premium.

Key Takeaways

1. Maximum profit: The ceiling for your profit is Rs. 30, derived from the difference between the strike price and your stock purchase price (920 – 900), plus the Rs. 10 premium.
2. Profit limits: No matter how high the stock price goes, your profit caps out at Rs. 30 due to the sold call option.
3. Downside risk: Keep in mind that your losses can be significant if the stock price declines substantially. So, pick a fundamentally strong stock to implement this strategy.
4. Break-even point: In this instance, the break-even point stands at Rs. 890, calculated by subtracting the Rs. 10 premium from your Rs. 900 stock price.

In summary

Covered call option strategy offers a way to generate additional income from your stock holdings. But it’s important to be aware of the risks and the ceiling on your potential profits.

Opt for this strategy with stocks that have strong fundamentals, and be aware of your break-even points. It’s a balancing act between maximising returns and managing risks.

As always, investing is not just about speculation but it also involves wise choices.