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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.
Read the blog to find out how you can employ this strategy in your options trades.
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.
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.
When the call option expires, these outcomes are possible:
- If the stock price closes above the strike price of the call, the buyer will purchase your stock, but you keep the premium.
- 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.
- If it doesn’t change, the premium you earned for selling the call option represents your profit.
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.
However, if you expect significant price swings in your stock, this strategy might not be optimal.
Why use covered calls?
- Additional income: You can generate extra earnings on the stock you already own.
- Downside protection: In the event of minor stock price declines, the option premium can act as a cushion.
- 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. Owning the stock and understanding the market conditions are two prerequisites for this strategy.
The process
- Choose an appropriate strike price for selling the Call option. This has to exceed the stock’s current market price.
- You sell, or ‘write,’ a Call option against your stock at the strike price you’ve chosen.
- The moment you write the call, you receive a premium.
- Keep an eye on the stock price and the option’s expiration date.
As the option’s expiration approaches, you have a couple of choices:
- Close the position: Buy back the Call option to close the position.
- Rollover: If you believe the stock will continue to move sideways or slightly upward, you can write another Call option with a new expiration date.
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:
| Spot prices | Long price | Call strike | Call premium | ITM / OTM | P/L on spot | P/L on option | Net P/L |
| 870 | 900 | 920 | 10 | OTM | -30 | 0 | -20 |
| 890 | 900 | 920 | 10 | OTM | -10 | 0 | 0 |
| 910 | 900 | 920 | 10 | OTM | 10 | 0 | 20 |
| 920 | 900 | 920 | 10 | ATM | 20 | 0 | 30 |
| 940 | 900 | 920 | 10 | ITM | 40 | -20 | 30 |
| 960 | 900 | 920 | 10 | ITM | 60 | -40 | 30 |
Two specific cases:
- 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.
- 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.
In summary
The 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.
FAQs
It is nearly impossible to identify strategies in the stock market, that are always profitable. Similarly, a covered call may or may not be profitable. However, the premium involved can either increase the profit or restrict the loss in a covered call.
Yes, covered calls can lose money if the stock’s spot price goes below the call’s strike price. However, the loss can be made good to the extent of the premium received.
In a volatile market, using covered calls could result in two pitfalls:
If the stock price soars beyond the strike price, you miss out on the additional gains.
Conversely, if the stock price plunges, you could face losses cushioned only by the initial premium received.
An uncovered call option is also called a naked call. This is the regular call option where the writer does not hold shares before entering a contract to sell them. So, the writer/seller of the contract must buy the shares from the market if the buyer wishes to exercise the contract.
A covered call is a neutral to bullish strategy. This is because the call options seller speculates the stock prices to increase, due to which the options buyer will execute the contract. This helps the seller sell existing shares along with earning additional premiums.