Derivatives Trading Basics
by 5paisa Research Team Last Updated: 2023-07-28T15:40:06+05:30
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The covered call strategy allows investors to generate income from their existing stock holdings, offering downside protection. The strategy is used both by institutional as well as retail traders and is considered to be a conservative strategy.

This article will focus on covered call meaning, strategies, features, advantages, and disadvantages. So if you are looking for detailed information on the covered call strategy, you have come to the right place. All you need to do is hold your patience and read till the end. 
 

What Is A Covered Call?

Covered calls refer to a popular option selling strategy. In this strategy concerning the covered call, the shares of a particular stock are owned by an investor who sells call options against the shares. 

A call option refers to a contract that assigns the buyer the right but not the obligation to buy the underlying stock at a strike price (a price that is predetermined) within a particular time frame. On selling the call options, a premium is earned by the investor from the option buyer. 

The term covered signifies that the underlying share is already owned by the investor, which serves as collateral for the call options that have been sold. This represents that if the call option is exercised by the option buyer who intends to purchase the stock, the share can be delivered to the investor without the need to make a separate purchase. 

The covered calls are used by investors who entertain a neutral to slightly bullish outlook concerning the stock. It offers an effective strategy for the generation of additional income and enhancement of the returns on stock investment, especially during the low volatility of the market. 
 

Understanding Covered Calls

To ensure a deep understanding of covered calls, it is essential to know how the entire procedure works. The shares of a particular stock are owned by the investor in their portfolio, which serves as collateral for the sold options.

Each call option represents the right, not the obligation, on the buyer's part to buy a specific number of shares at a strike price within a given time frame. The investor receives a premium against the sold call options, an immediate income. 
 

What Is The Objective Of Covered Call Strategy?

There exists two-fold objective of the covered call strategy, which are discussed below in detail:

Generation Of Income: 

The main objective of the covered call strategy is the generation of income through the premiums received against the selling of call options. These premiums become the immediate income on the part of the investors. 

Therefore by consistently selling the covered calls, investors can generate a stable income other than any dividends received from entertaining the ownership of the stock. 

Downside Protection: 

Besides the generation of income, there is another objective of the covered call strategy, which is to offer a degree of downside protection. The premiums secured against the selling of the call options partially offset potential losses in the value of the stock. 

With the decline of stock price, the premium serves as a cushion, thereby decreasing the overall impact of the depreciation of the stock. Therefore, the covered call strategy acts as a potential method of mitigating losses and securing a degree of downside protection on the part of the investor. 
 

Features of the Covered Call Strategy

The covered call strategy offers numerous notable options that make it an attractive option for investors as far as their trading strategies are concerned. The most notable covered call strategy features are as follows:

●    The main feature that the covered call strategy represents is its ability to generate income in the form of premiums. 
●    The potential for downside protection is another critical feature of the covered call strategy.
●    Allowance for the appreciation of capital. The holding of the underlying stock can increase in value over time. 
●    Investors get options for customisation and flexibility through a covered call strategy.
●    The covered call strategy entertains wide availability and can be implemented in numerous markets.
 

Benefits Offered By Covered Call Strategy

Additional Income Generation:

The most crucial advantage of a covered call strategy is being able to generate additional income. Through the sale of call options for the stocks that they already own, a premium is received by the investor from the option buyers, which serves as an immediate source of income for the investor.

Reduction Of Risks: 

A level of downside protection is also provided by a covered call strategy, which reduces the amount of risk. The premiums mainly serve as a cushion against any potential losses in the valuation of the stock. If the stock price declines, the received premium will automatically cover some of the losses. This, however, reduces any negative impact on the portfolio of the investor. 

Enhancement Of The Potential Of Return:

While the strategy limits the potential upside in case the price of the stock rises, it still offers capital appreciation in the long run as the investor continues holding the stock, whose value may appreciate with time. 

Customization And Flexibility:

The investors are offered the options of customisation and flexibility where they can select the various strike prices and date of expiration for the call options based on their market outlook and goals of investment. Therefore the investors can customise their strategies with their risk-taking capability, desired levels of income, and holding of specific stocks.

Diversification Of The Portfolio:

Incorporating covered calls into the investment portfolio also adds an element of diversification. As the strategy combines the ownership of stock with options trading, it offers the investor access to both options and the equity market, thereby offering a potential diversification of the approach toward investment. 

Regular Flow Of Cash:

The strategy can also offer the investors a stable and consistent flow of cash from the received premiums. This can be excessively beneficial for investors who are more income-oriented and depend on the distribution of periodic cash to cover their expenses and reinvest in other opportunities. 
 

How Does The Strategy of Covered Call Work?

A step-by-step explanation of how the covered call strategy work is given below:

●    Ownership Of The Stock: A certain number of shares of a particular stock must be owned by investors in their portfolio. The number of shares must be 100 for each call option they are willing to sell.
●    Call Option Selling: The investor sells the stock's call options that they own. Every call option provides the right, but not the obligation, on the part of the buyer to buy a specific number of shares (usually 100 shares) at the strike price within a specific period of time. 
●    Collection of Premium: Against the selling of call options, a certain amount of premium is received by the investor from the buyers. The premium serves as the price paid for the contract for the option and serves as an immediate income for the investor. 
●    Obligation For Selling Shares: With selling the call options, an obligation is being undertaken by the investor. If the buyer of the call option intends to exercise their right to purchase shares at the strike price on or before the date of expiration, the investor must sell the shares at the strike price that they agreed upon previously.
●    Potential Outcomes: If the price of the stock remains below the predetermined price until the date of expiration, the call option expires worthless. The premium received by the investor is acknowledged as profit who continues to own the shares and can sell more call options in the future. But if the price of the stock goes above the strike price, the call option is exercised where the investor sells the share to the buyer of the call option at the predetermined price. However, the premium remains with the investor, but the potential upside is limited to the strike price. 
 

Covered Call Strategy: Maximum Profit and Maximum Loss

The achievement of maximum profit becomes possible in a covered call strategy when the price of the stock remains below the strike price until the expiration date. On the other hand, the maximum loss occurs when the price of the stock drops significantly below the initial stock price. However, it is essential to note that maximum loss in a covered call strategy is restricted to the decline of the stock and not unlimited, as in the case of a naked call strategy. 

Advantages and Disadvantages Offered By Covered Calls

The covered call strategy comes with various advantages and disadvantages, which are discussed below:

Advantages of Covered Calls:

●    Generation of income by selling call options of the stocks already owned by the investor.
●    The premiums secured from the sale of covered calls are a cushion against loss.
●    Offers potential for the appreciation of capital as the value of the stocks held by the investor would increase over time.
●    Investors can manage their exposure to risk well.
●    Offers various options for customisations and flexibility on the part of the investor.

Disadvantages of Covered Calls:

●    The most concerning disadvantage of the covered call strategy is that upside gains are restricted.
●    There exists a risk of call options being exercised.
●    Options trading includes transaction charges, including fees and commissions. 
●    The active management and monitoring of the movement in prices require time and effort on the part of the investor.
 

When To Use The Strategy Of Covered Call Option?

The covered call option strategy can be implemented in various situations depending on the goal and market outlook of the investor. The strategy can be considered in some of the scenarios mentioned below:

●    Periods of low market volatility or when the investor expects the price of the stock to remain stable.
●    An investor's neutral to a slightly bullish outlook on the price of the stock.
●    A tool for managing potential risks concerning a stock
●    For portfolio diversification
●    Enhancement of income for the stocks that pay a dividend.
 

Example of a Covered Call

Let's assume an investor owns 100 shares of a company named XYZ, currently trading at Rs.1000 per share. The investor assumes that the price of the stock will remain stable in the near term. 

To generate additional income, the investor decides to undertake a covered call strategy, intending to sell the call option at a strike price of Rs. 1100 per share with a specific expiration date. 

The buyer of the call option and the investor agrees upon a premium of Rs 100 per share; therefore, a total of Rs. 10,000 is earned by the investor as a premium. If the price of the stock remains below Rs 1100 by the expiration date, the shares are kept by the investor along with their premium. 

But if the price rises above Rs 1100, the investor may be bound to sell the shares at the strike price, where the maximum profit of the investor would be the received premium along with the potential gain of the stocks up to the strike price, which is Rs. 1100. 
 

How To Make Use Of LEAPS In A Covered Call Write?

To use LEAPS in a covered call write, follow the steps mentioned below:

●    Select the stock that you feel has the potential for appreciation of price. 
●    Look for the LEAPS option on the stock chosen.
●    Buy the LEAPS
●    Sell call options
●    Monitor the price of the stock constantly and its price movement.
●    Manage the expiration of the call option. If the price of the stock is above the strike price, one may require to sell the LEAPS position at the strike price. 
 

Do Covered Calls Offer Investors With A Profitable Strategy?

Covered calls can prove to be a profitable strategy under certain market conditions. The strategy helps the investors to reduce risk by generating income from selling option calls. 

However, the covered call profitability depends on a variety of factors, such as the selection of sticks, strike price, volatility of the market, and trade timings. To emerge successful in implementing the covered call strategy, careful analysis, active monitoring, and proper management of risk are essential. 
 

How Much Risk Is Associated With Covered Calls?

Although covered calls serve as an effective strategy, an investor needs to know that they come with inherent risks. The selling of covered calls encompasses the obligation to sell the underlying stock at the strike price once the call options are exercised. 

Therefore this results in the limitation of upside gains if the price of the stock rises significantly. Additionally, the volatility of the market, selection of stocks, and timings can also impact the level of risk associated with implementing the strategy. 
 

Can One Make Use Of Covered Calls In Their IRA?

Yes, one can use covered calls in IRA or Individual Retirement Account, but some restrictions are associated. While the strategy can generate potential income, they encompass option trading. 

This may be subject to limitations within IRA; if the custodian of the IRA allows options trading and especially covered calls, then one can freely adopt the strategy. Therefore it deems necessary to consult with the IRA custodian first before adopting this strategy.
 

Is There Anything Known As A Covered Put?

Yes, covered put work in a similar manner as covered calls, except for the fact that one would be writing an option against a position that is short, representing a stock that has been borrowed and later sold in the market.

Conclusion

Thus, to sum up, covered calls can serve as an intriguing strategy for investors looking for efficient risk management and generation of income in their investment portfolios. By merging the ownership of stock with the selling of call options, the investors can enhance their potential returns in a moderate appreciation of stock price. 

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Frequently Asked Questions

Selling the underlying stock before the covered call expires can be risky, as it exposes the investor to potential losses if there is a decline in the stock price.

The risk involved in a covered call is that upside potential is limited even if the price of the stock rises. 

The significant benefit of a covered call is that it offers the investor some additional income in the form of the premium received.