In this article, we will discuss:
- What Are Strategy Legs?
- What Will Be The Payoff?
- Who Can Deploy This Strategy?
- When Should This Strategy Be Deployed?
- Greeks Corner
- Things To Keep In Mind
Covered call strategy is a popular option trading technique that allows investors to generate income and reduce risk on their stock holdings.
What Are Strategy Legs?
In a covered call strategy, you should hold the underlying stock and sell out of the money (OTM) call option with equal quantity. This means that you sell a call option that has a higher strike price than the current market price of the stock. For example, if you own 100 shares of Reliance Industries, which is trading at ₹2000 per share, you can sell a call option with a strike price of ₹2100 and an expiry date of one month.
If you don't have cash to hold the underlying stock, you can buy one future underlying stock and sell one OTM call option. This is called a synthetic covered call strategy. For example, if you don't own Reliance Industries shares, future contract of Stock X and sell a call option with a strike price of ₹2100 and receive a premium of ₹5 per share.
What Will Be The Payoff?
The payoff of a covered call strategy depends on the movement of the underlying stock price. There are three possible scenarios:
Scenario 1
The stock price rises above the strike price of the call option. In this case, the call option will be exercised by the buyer, and the investor will have to sell the stock or the future contract at the strike price. The investor will earn the difference between the strike price and the purchase price of the stock or the future contract, plus the premium received from selling the call option. For example, if the stock price rises to ₹2200, the investor will earn ₹100 (₹2100 - ₹2000) per share from the stock or the future contract, and ₹5 per share from the call option, for a total profit of ₹105 per share.
Scenario 2
The stock price stays below the strike price of the call option. In this case, the call option will expire worthless, and the investor will keep the stock or the future contract and the premium received from selling the call option. The investor will earn the premium as income, and the stock or the future contract will retain its value. For example, if the stock price stays at ₹2000, the investor will earn ₹5 per share from the call option, and the stock or the future contract will remain at ₹2000 per share.
Scenario 3
The stock price falls below the purchase price of the stock or the future contract. In this case, the call option will expire worthless, and the investor will keep the stock or the future contract and the premium received from selling the call option. However, the investor will incur a loss on the stock or the future contract, which will be partially offset by the premium. For example, if the stock price falls to ₹1900, the investor will lose ₹100 (₹2000 - ₹1900) per share on the stock or the future contract, but will earn ₹5 per share from the call option, for a net loss of ₹95 per share.
Who Can Deploy This Strategy?
This strategy can be deployed by investors who have a bullish or neutral outlook on the underlying stock, and who are willing to limit their upside potential in exchange for income and downside protection. Since this strategy involves selling call options, the investor must have sufficient margin in their account to cover the potential obligation. This strategy is also suitable for investors who want to reduce the cost basis of their stock or future holdings, and who are comfortable with selling their holdings at the strike price of the call option.
When Should This Strategy Be Deployed?
This strategy should be deployed when the investor expects the underlying stock to rise moderately or stay range-bound in the near term, and when the implied volatility of the call option is high. Implied volatility is a measure of how much the market expects the stock price to fluctuate in the future, and it affects the premium of the option. A high implied volatility means a higher premium, which translates into more income for the investor. However, a high implied volatility also means a higher probability of the stock price moving beyond the strike price of the call option, which would result in the investor losing the stock or the future contract.
Greeks Corner
When the stock moves sideways, profitability stems from theta decay within the call option, generating income as time passes. Alternatively, if the stock trends upwards, profits accrue from the delta of futures, capitalising on the price movement to generate returns.
Things To Keep In Mind
- Rolling out: This involves buying back the existing call option and selling a new call option with the same strike price but a later expiration date. This allows the investor to extend the duration of the covered call strategy and collect more premium income.
Covered option trading is a versatile and rewarding strategy that can help investors in the Indian stock market to manage risk and generate income. By understanding the basics, benefits, and types of covered option strategies, investors can enhance their portfolio performance and achieve their financial goals. Try Options B.R.O. It is a feature in the Samco trading app that helps you select the best options trading strategy based on your market view, risk appetite, and return expectations. It also provides you with the optimal strike prices, expiry dates, and quantities for your chosen strategy.
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