A covered call option strategy, known as a buy-write strategy, is an options trading strategy that involves buying an underlying asset such as a stock, and then selling a call option on that same asset. The goal of this strategy is to generate income from the premium received from selling the call option while also benefiting from potential price appreciation of the underlying asset.
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How covered call (CC) option strategy works ?
Buy the underlying asset: The first step is to buy a stock and/ or exchange-traded fund (ETF).
Sell a call option: Next, sell a call option on the underlying asset you just purchased. The call option gives the buyer the right to purchase the underlying asset at a specified price (strike price) on or before a specified date (expiration date).
Collect premium: In exchange for selling the call option, you receive a premium from the buyer, which is the amount of money they pay for the option.
What happens when I sell a covered call ?
When you sell a covered call, three possible scenario can unfold depending on the price movement of the underlying asset and the expiration of the call option.
The stock price remains below the strike price:
If the price of the underlying asset remains below the strike price by the expiration date of the call option, the option will expire worthless. In this scenario, the investor selling the CC keeps the premium they received from selling the call option as profit. They can then sell another call option (of another expiry period) to generate additional income or hold onto the underlying asset.
The stock price rises above the strike price:
If the price of the underlying asset rises above the strike price, the call option may be exercised. Then the investor may be obligated to sell the asset at the strike price. In this scenario, the investor will still keep the premium received from selling the call option, which reduces their cost basis in the underlying asset. However, they may miss out on potential profit if the asset’s price continues to rise beyond the strike price.
The stock price falls significantly: See below “Risk and / or limitations of trading covered calls”
When can I sell a covered call against my holdings ?
The covered call strategy is often used by investors who own stock and want to generate additional income on their holdings.
It is also used by traders who are neutral to slightly bullish on the underlying asset and want to generate income while limiting potential downside risk. However, it does come with some risks, such as potentially missing out on significant price appreciation if the asset’s price rises above the strike price.
The strike price at which a CC option can be sold depends on several factors, such as the current market price of the underlying asset, the investor’s outlook on the asset’s price movement, and the desired level of income or protection.
Generally, a CC option is sold with a strike price that is slightly higher than the current market price of the underlying asset. This is because the investor selling the call option is essentially giving up the potential for additional profit beyond the strike price in exchange for receiving the premium.
Example of a covered call and break-even point
For example, if an investor owns a full lot of Infy shares i.e., 400 shares which is currently trading at Rs. 1420 per share. The investor may sell a CC option of May 2023 expiry period with strike price of Rs. 1500 at premium of Rs.20 per share. This sold call now has break-even point of Rs.1520 (Rs.1500 sold strike + Rs. 20 premium).
The break-even point is the point at which the investor neither makes nor loses money on the trade.
If the stock price remains below Rs.1500 by expiration date, the call option will expire worthless, and the investor keeps the premium of Rs.20 (400 x 20 = Rs.8000) as profit.
If the stock price rises above 1520, the investor may be obligated to sell the shares. Thus, the investor would make the following amount:
Gain from stock: 1520 – 1420 = 100
Profit from stock: 100 * 400 = Rs.40,000/-
Loss from sold option = 0 (as break-even is at 1520)
Hence, total profit is Rs.40,000/- on Rs. 5,68,000 investment which is 7.04% return on the investment.
As it can be seen, the investor is making money in both the cases i.e., either the stock has fallen or it has shot up beyond the break-even point.
Which Strike price should I select to sell a covered call ?
There is no hard and fast rule for how far a covered call option can be sold. It ultimately depends on the individual investor’s risk tolerance, market outlook, and investment goals. However, it is generally recommended to sell call options with strike prices that are not too far out of the money. These options are likely to have better premiums but the possibility of stock reaching to that levels is also higher.
Risk and / or limitations of trading covered calls :
The stock price falls significantly:
If the price of the underlying asset falls significantly, the investor will experience notional loss on the trade. However, the premium received from selling the call option acts as a buffer against potential losses, as it reduces the cost basis of the underlying asset. Sometimes, the stock may not get back up after the loss. In such case, the investor will not be able to sell covered calls.
So, it is very important to choose a stock / ETF that is not expected to fall significantly. While initiating the covered call strategy, your view on the stock/
The stock price rises significantly:
The gains in the stock will offset by the loss in the sold call option, thereby losing very good profit making opportunity in stock.
What can be the underlying assets for covered calls ?
The underlying assets for covered calls in the Indian market can be stocks, exchange-traded funds (ETFs), or index funds.
Stocks trading in Futures & Options segment (F&O stocks) and indices like Nifty & Bank Nifty are the underlying assets for trading a covered call strategy.
It is important to note that the underlying asset for a covered call strategy should have a high trading volume and liquidity to ensure that the investor can enter and exit the trade at a fair price. Additionally, investors should conduct thorough research and analysis on the stocks before initiating a covered call strategy.
What are the benefits of covered call
The covered call option strategy can offer several benefits to investors. Here are some of the key benefits of the covered call strategy:
Generates additional income: One of the main benefits of the covered call strategy is that it generates additional income for investors. By selling a call option on a stock they already own, investors can collect a premium, which can boost their returns even if the stock price does not increase.
Provides downside protection: The covered call strategy also offers some downside protection to investors. The premium collected from selling the call option reduces the investor’s cost basis in the stock and provides some cushion against potential losses.
Limits risk and increases predictability: The risk in the covered call strategy is limited to the cost of purchasing the underlying stock, while the potential reward is limited to the strike price of the call option. This creates a more predictable risk-reward profile compared to naked option strategies or directional trades.
Enhances portfolio returns: The covered call strategy can be used to enhance portfolio returns in a variety of market conditions. If the stock price increases, the investor can profit from the capital appreciation and the premium collected from selling the call option. If the stock price remains flat or declines, the investor can still generate income from the premium and potentially avoid some of the losses.
Provides flexibility: Finally, the covered call strategy provides investors with flexibility. Investors can adjust the strike price and expiration date of the call option to suit their investment objectives and market outlook. They can also roll over the position by selling a new call option on the same stock after the current option expires, potentially generating additional income.
Overall, the covered call strategy can be an effective way for investors to generate additional income, protect against potential losses, and enhance portfolio returns in a variety of market conditions.
