Covered Call Options Strategy
The covered call options strategy offers an effective way for traders to protect their substantial shareholdings. By selling out-of-the-money (OTM) Call Options in proportion to their owned shares, traders can earn premiums while waiting for the stock price to rise. This strategy is best suited for a bullish market view and carries limited rewards with unlimited risks.
Understanding the Covered Call Strategy
The covered call strategy involves selling OTM Call Options, mirroring the number of shares owned, to generate income. The call option will not be exercised until the stock price surpasses the strike price. Until then, the seller continues to earn the premium. This strategy acts as an insurance of sorts for large shareholdings.
When to Use the Covered Call Strategy
The covered call strategy is ideal when you hold a moderately bullish view of the market and expect the stock prices to rise modestly in the future.
Example: Implementing the Covered Call Strategy
Suppose you are a shareholder of HDFC (Housing Development Finance Corporation Limited) and believe that its stock price will increase in the near term. To employ the covered call strategy, you can sell HDFC OTM Call Options at a desired selling price. The premium received from selling these call options becomes your income.
For instance, if you own 100 shares of HDFC Company trading at Rs. 50 in May, you can implement the covered call strategy by selling June 55 Calls (Lot Size 100) at a premium rate of Rs. 2. This results in a premium income of Rs. 200 if you sell the option.
HDFC Stock Price: Rs. 50
Short Call Option Strike Price: Rs. 55
Lot Size: 100
Premium Received: Rs. 200
Breakeven Point: (Purchase Price of Underlying + Premium Received) = Rs. 48
Possible Scenarios with Covered Call Strategy
Scenario 1: The stock price of HDFC increases to Rs. 57
In this case, the strike price at expiry (Rs. 57) is higher than the sold call option’s strike (Rs. 55). Consequently, the call option would be assigned, and you would sell your holding shares to earn a profit of (Rs. 55 – Rs. 57) x 100 = Rs. 200. When adding the Rs. 200 premium received from selling the call option, your total profit would be Rs. 400.
Scenario 2: The stock price of HDFC drops to Rs. 40
In the event of the stock price receding to Rs. 40, an incurred loss of (Rs. 50 – Rs. 40) x 100 = Rs. 1000 emerges. Notably, this loss remains confined to the realm of theory, as you abstain from offloading your shares. The blow is softened, however, by the Rs. 200 premium procured, resulting in a cumulative loss of Rs. 800.
Covered Call Option Strategy Payoff Schedule
|Stock Price at Expiry||Net Payoff (Rs)|
Risk Profile of Covered Call Strategy
The maximum loss in this strategy is determined by the underlying’s price drop. Loss occurs when the underlying price falls below its purchase price and is calculated as follows: Loss = (Purchase Price of Underlying – Price of Underlying) + Premium Received.
Reward Profile for Covered Call
The reward in this strategy is limited. It involves earning a premium from selling the call option, and the maximum profit is realized when the purchase price of the underlying rises above the strike price: Max Profit = [Call Strike Price – Stock Price Paid] + Premium Received.
Maximum Profit Scenario for Covered Call
Maximum profit is achieved when the underlying rises to the same level as the strike price or higher.
Maximum Loss Scenario for Covered Call
The maximum loss is capped at the premium received.
Benefits of Covered Call
The covered call strategy offers multiple benefits, including generating income from your stocks and benefiting from various stock movements, such as sideways, marginal falls, and rises.
The Disadvantages of Covered Calls
One of the main disadvantages of covered calls is the exposure to unlimited risk for limited reward.
How to Exit a Covered Call Strategy
You can exit the covered call strategy in the following ways:
- Exercise the call option when the strike price is above the stock price.
- Retain the premium received by waiting for the option to expire.
- Buy the call option and sell the underlying.