What is a Covered Call Strategy and How Does It Work?

What is a Covered Call?

A covered call option strategy is selling a call option on an underlying asset that the writer already owns. To create an income stream, the investor who has a long position in an asset writes call options on the same asset.

Since the seller may deliver the shares if the buyer of that call option wants to exercise, the investor's long position in the asset serves as the cover.

How Does a Covered Call Work?

Let us focus on understanding how a covered call strategy works through an example. Consider a trader holding 100 shares of Reliance Industries (RIL).

RIL is currently trading at ₹1,300 per share. In the upcoming month, the trader expects that the stock will remain between ₹1,300 and ₹1,350. Thus, the trader chooses to sell a call option with a ₹1,350 strike price. Each share has a ₹20 option premium. The option expires after a month.

Now there can be three different scenarios:

Scenario 1: RIL Stays Below ₹1,350 

The call option expires worthless. The writer keeps the premium amount of ₹20 and earns:

(₹20 × 100 shares) = ₹2,000, and owns the 100 shares of RIL.

Scenario 2: If RIL Goes Above ₹1,350

The call option can be exercised at maturity.

The trader has to sell his shares at ₹1,350. He will not be able to gain from any further rise above this level.

The gain on the stock is:

(₹50 × 100 shares) = ₹5,000

He also earns the premium amount of ₹2,000. So, the net gain is ₹7,000 before considering transaction costs and taxes.

Scenario 3: RIL Stays at ₹1,250

The call option expires worthless.

The writer gets a ₹2,000 premium but incurs an unrealised loss of ₹5,000 due to a fall in the share price by ₹50 per share.

Thus, his net unrealised loss is ₹3,000 before transaction costs and taxes.

Objectives of Using a Covered Call

The main objective of a covered call strategy is yield enhancement rather than aggressive capital appreciation. Here are the other objectives:

1. Income Generation

Collecting the option premium is the primary goal. Selling a covered call may produce an extra 1%–2% monthly yield for many low-dividend Indian blue-chip stocks.

2. Improving Returns

The price of a stock may not change for months in a sideways or slightly positive market. A buy-and-hold investor receives zero returns in this situation. On the other hand, a covered call investor outperforms the underlying stock by earning the option premium.

3. Monetising Long-Term Holdings

A large number of Indian investors hold equities for several years. Selling a far Out-of-the-Money (OTM) call enables you to make rent on that ‘digital real estate’ while you wait for years to liquidate your primary assets.

4. Lowering the Break-Even Price

You essentially lower the cost of your investment each time you receive a premium. For example, your net cost would be ₹707 if you purchased HDFC Bank Ltd. for ₹727 and received a ₹20 premium. This offers a tiny ‘cushion’ if the stock price declines. 

5. Dampening Portfolio Volatility

Your portfolio's overall value varies less than the market when you get a premium. The value of the call you sold decreases along with the stock, which is a profit for you and helps to partially offset the loss on your shares.
 

What are the Components of a Covered Call?

When the covered call strategy is used, there are several possible outcomes. Some of them are:

1. Stock Price Increases

In this case, a trader will benefit from a guaranteed short-term profit as they have essentially locked in the stock's sale price by selling a call option. Furthermore, he or she will get the premium paid by the call option buyer. It is a favourable circumstance.

2. Stock Price Decreases

Since the person was able to pocket the premium from the sale of the call option, they will have minimal protection against the downside in this case. You can use the premium amount you get to lessen the impact of the loss you experienced due to the stock price decline.

3. Stock Price Remains the Same

The premium that the investor collected by selling the stock's call option contract would be the profit while the stock's price remained unchanged. This is the case whether or not the buyer exercises the option. In certain cases, the buyer may not choose to exercise the option, which allows you to keep your shares and benefit from the premium.

Benefits of Covered Call

The covered call strategy has the following main benefits:

1. Reliable Source of Income

Covered calls are a reliable source of revenue. In volatile or sideways markets, this is quite helpful. This extra revenue has the potential to greatly increase your total profits over time.

2. Cost Saving

Your purchasing cost is essentially decreased by the premium you receive. This reduces your break-even point and offers a tiny buffer against losses. It somewhat reduces the risk of owning stocks.

3. Easy to Understand

For beginners, the covered call strategy is very simple and an effective option to start trading.

Limitations of Covered Call

The covered call strategy is not ideal, even though it can produce consistent revenue. Some of its risks are:

1. High Risk

The strategy is not risk-free even if it offers some safety. Even if the prices drop significantly, you can still lose a lot of money.

2. Restricted Gains

Covered calls may restrict your potential gains if the market is very bullish. It could be more advantageous to just hold the stock in certain circumstances.

3. Not Appropriate for Everyone

To execute a covered call, the trader must own the underlying shares. This may not be appropriate for everyone because it requires a capital commitment.

Apart from using different options trading strategies, you should also start learning about how derivatives like futures, options, and swaps work by going through the Market Guide of 5paisa.

When to Use a Covered Call Option Strategy?

Market conditions are very crucial when using a covered call strategy. When markets are steady or merely slowly increasing, the technique usually performs better.

The premium collected might contribute significantly to the total return under sideways situations. Even if there is little movement in the stock price, the premium earned stays constant.

This strategy is also employed by certain investors who want to sell a stock at a specific price but are hesitant to do it immediately. By selling a call, they can get closer to that objective and earn money.

However, participation in bigger profits may be restricted when markets are extremely optimistic due to the constrained upside.

Tips to Use Covered Call Strategy Effectively

The following tips can help you employ the covered call strategy more successfully:

• It is preferable to choose fundamentally sound stocks. In addition to lowering your downside risk, this allows you to retain the stock for an extended period of time.
• Monitoring price changes and options holdings is always preferable. When market circumstances shift, this might help you make adjustments or exit the position.
• To balance income and upside potential, choose a strike price that is somewhat higher than the current market price. Your shares could be swiftly called away if you are too near.
• Covered calls are best used in sideways or slightly positive situations. Steer clear of them during significant uptrends when your profit can be constrained.

Mistakes to Avoid While Using a Covered Call Strategy

When using the covered call strategy, traders frequently commit a few blunders. The following are some common mistakes:

• Your stock is more likely to be called away fast if you sell calls too close to the present price. Your profit may be limited as a result.
• Traders often disregard the general trend of the market. In sideways markets, the covered call strategy works well. You will unnecessarily restrict your gains if you apply it during a significant rise.
• While excessively long expiries lock your stock for an excessive amount of time, choosing very short expiries may result in low premiums.
• Many traders are unaware that they must sell their shares if the stock surpasses the strike price. Your long-term investing strategy may be disrupted if you are unprepared for this.

Final Thought

A covered call strategy might be quite helpful for you to go for extra returns in your current portfolio. It achieves a balance between controlling risk and generating a steady income. You must sell a call option on a stock you already own to use this strategy. In sideways and mildly positive markets, this strategy performs well.

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