What Is Covered Call Options Trading Strategy?

What Is Covered Call Options Trading Strategy?
by Nilesh Jain 21/02/2017

A covered call options trading strategy is an Income generating strategy which can be initiated by simultaneously purchasing a stock and selling a call option. It can also be used by someone who is holding a stock and wants to earn income from that investment. Generally, the call option which is sold will be out-the-money and it will not get exercised unless the stock price increases above the strike price.

How should you use the covered call Options Trading strategy?

Choosing between strikes involves a trade-off between priorities. An investor can select higher out-the-money strike price and preserve some more upside potential. However, more out-the-money would generate less premium income, which means that there would be a smaller downside protection in case ofstock decline. The expiration month reflects the time horizon of his market view.

Strategy Buy Stock & Sell call option
Market Outlook Neutral to moderately bullish
Breakeven(Rs.) at expiry Stock price paid-premium received
Maximum Risk Stock price paid-call premium
Reward Limited
Margin required Yes

Let’s try to understand the Covered Call Options Trading Strategy with an Example:

Current ABC Ltd Price Rs. 8500
Strike price Rs. 8700
Premium Received (per share) Rs. 50
BEP (strike Price - Premium paid) Rs. 8450
Lot size (in units) 100

Let us consider the following scenario: Mr. X has purchased 100 shares of ABC Ltd. for Rs.8500 and simultaneously sells a call option with a strike price of Rs. 8700 for Rs.50 which means that Mr. X does not think that price of ABC Ltd will rise above Rs. 8700 till expiry. Thus, the net outflow to Mr. X is (Rs.8500-Rs.50) Rs. 8450.

The upside profit potential is limited to the premium received from the call option sold plus the difference between the stock purchase price and its strike price.

In the above example, if stock price surges above the 8700 level, then the maximum profit would be calculated as:(8700-8500 +50)*100 = (250*100) = Rs. 25,000. If the stock price stays at or below Rs. 8700, the call option will not get exercised and Mr. X can retain the premium of Rs. 50, which is an extra income.

For the ease of understanding, concepts such as commission, dividend, margin, tax and other transaction charges have not been included in the above example.

Any increase in volatility will have a neutral to negative impact as the option premium will increase, while a decrease in volatility will have a positive effect. Time decay will have a positive effect.

Analysis of Covered Call trading Strategy:

The covered call strategy is best used when an investor wishes to generate income in addition to any dividends from shares of stocks he or she owns. However, it may not be a very profitable strategy for an investor whose main interest is to gain substantial profit and who wants to protect downside risk.