Covered call strategy – Meaning, Features, Benefits

In this article, we will cover

• What is the Covered call strategy?
• Features of covered call strategy
• Benefits
• Limitations
• Conclusion

Investors use various option trading strategies to hedge and protect their downside risk in the market. There are around 400 option strategies. Among the safest and most widely used option strategy is covered call strategy. In this article we will try to understand the covered call strategy in detail.

What is Covered call strategy?

Covered Call as the name suggests is a strategy where the position is covered. In this strategy, Call Options are sold but only when the underlying is owned by the investor or trader. As you might be aware selling options involves unlimited risk. However, in Covered Calls the risk and profits are covered. Thus it’s a good strategy to earn extra profits on your investments or holdings.

Let’s understand this with an example.

Suppose there is an investor who has invested in a stock at Rs 100. The intention is to hold the stock for a long period of time to earn a return of say 20%. Even if the price of the stock goes down the investor doesn’t intend to sell it & keeps holding till the target price is reached. The stock would only be sold if it gets overheated and reached 20% very quickly. Thus the investor can sell a call of strike price Rs. 120 say at a premium of Rs 2. Now, till the expiry 4 things can happen.

• Scenario 1: When the stock falls below the purchase price

First, the stock may go down to say Rs. 97. Thus the Call sold will expire at zero. In this scenario, there will be an unrealized loss of Rs. 10 on his investments. However, the Call sold which expired at zero will give a realized profit of Rs. 2 taking his net buying price to Rs. 98 i.e. 100 - 2. This will ensure that the investor’s losses are minimized.

• Scenario 2: When the stock price remains stagnant

Secondly, the stock can go side way. In this case, the price remains at Rs 100 till expiry. So there won’t be any profit or loss on the investor’s stock holding. However, the call sold will expire at 0, earning him a net profit of Rs 2.

• Scenario 3: When stock price rises more than the purchase price but less than the call option

In the third case the stock rises but stays below Rs 120 say at Rs 110. In such a scenario, the investor’s stock holding will give him a profit of Rs 10 and even the call sold will expire out of money giving an additional profit of Rs 2. The profit will be maximum if the stock price is Rs. 120 at the time of expiry where the total profit would be Rs. 22 (20 in stock holding and 2 on-call sold).

• Scenario 4: When stock price rises above the call option strike price

In the final scenario, the stock price rises above Rs. 120 to say Rs. 140. Here, the Call sold will result in a loss of Rs. 18 but the invested stock would result in a profit of Rs. 40 resulting in a net profit of Rs. 22. In fact at any price above Rs. 120 the profit would be capped at Rs. 22. Thus as seen in the above 4 scenarios, 3 would result in net profit while only in the first case there can be a loss and that too unrealized. The only perceived shortcoming can be that the profit is capped above Rs. 120. However, in any case, the investor would have sold the stock at Rs. 120 as the target was achieved. Thus, as it can be seen, even though the profit is capped there is no realized loss

Features of Covered Call Strategy

• Covered call helps investors to generate income from the portfolio.
• Covered Call Strategy is a positive hedge strategy where the hedge results in additional profit but exponential profit is capped.
• Can earn income in the form of premium by selling option when the stock price goes up or down.

Benefits

• Helps to generate regular income:Most investors sell covered call to generate a regular passive income. It could be monthly or quarterly gains.
• Potential to earn more than the actual stock price:Through a covered call, an investor can earn more than the actual share price. For eg: If I buy a share at Rs 99 and sell a call for Rs 100 against a premium of Rs 10. Then if the share price reaches 100 and call is assigned then I earn 110 per share. Even if the actual share price never reaches Rs 110 and retracts from Rs 100 levels I have still made more than the actual price.
• Premium to limit downside risk when stock price goes down:In the event that the stock price falls, the premium received on call writing will help in reducing the downside risk up to that extent.

Limitations

• Opportunity loss when the stock makes a huge jump: The profit potential is limited in covered call option as the investor is obligated to sell the share at the strike price. Therefore, often an investor feels remorse when the stock prices rally far beyond the covered call.
• Risk when a stock falls below the break-even point: When the stock price declines below the break-even point, the investor will start to lose money. The break-even point is the buy price of the stock minus the option premium.

Conclusion

To conclude, the covered call option strategy helps an investor to earn income through premiums on a regular basis and offers protection to the extent of premium when the stock price falls.So don’t wait any longer, start trading in stocks and derivatives today, only at Samco Securities