Compare Strategies:

Covered Call Options Trading Strategy Explained

Published on Wednesday, April 18, 2018 | Modified on Wednesday, June 5, 2019

Covered Call

Covered Call Options Strategy

Strategy LevelAdvance
Instruments TradedCall + Underlying
Number of Positions2
Market ViewBullish
Risk ProfileUnlimited
Reward ProfileLimited
Breakeven PointPurchase Price of Underlying- Premium Recieved

A Covered Call is a basic option trading strategy frequently used by traders to protect their huge share holdings. It is a strategy in which you own shares of a company and Sell OTM Call Option of the company in similar proportion. The Call Option would not get exercised unless the stock price increases. Till then you will earn the Premium. This a unlimited risk and limited reward strategy.

Let's assume you own TCS Shares and your view is that its price will rise in the near future. You will Sell OTM Call Option of TCS at a price, where you target to sell your shares. You will receive premium amount for selling the Call option and the premium is your income.

When to use Covered Call strategy?

The covered call option strategy works well when you have a mildly Bullish market view and you expect the price of your holdings to moderately rise in future.

Example

Suppose you are holding 100 shares of ABC company trading at ₹50 in May. You are bullish on your holdings but are also worried about the downside i.e losses if there is fall in the price. In such a scenario, you can implement a Covered Call option strategy by selling a June 55 Call of Lot Size 100 at Over The Money (OTM) available at a premium of ₹2. Since you are selling an option, you will receive ₹2 X 100= ₹200.

ABC Stock Price₹50
Short Call Option Strike Price₹55
Option Lot Size100
Premium Received₹200
Break Even Point
(Purchase Price of Underlying - Premium Received)
₹48

Your total investments in the trade will be the cost of holding 100 shares minus the premium received i.e.

Cost of holdings (₹50 X 100= ₹5000) - Premium Received (₹200)= ₹4800

Now let's discuss about the possible scenarios:

Scenario 1: Stock price of ABC rises to ₹57.

Here the strike price on expiry (₹57) is greater than the strike price of sold Call Option (₹55). The Call Option in such a case would be assigned and you will sell the holding shares and make a profit of (₹57- ₹55) X 100= ₹200. Your total profit, after adding ₹200 from the premium received on selling the Call Option, would be ₹400.

Scenario 2: Stock price of ABC falls to ₹40

Your holding will lose (₹50-₹40= ₹10) X 100= ₹1000 in value. Since you would not be selling the shares, this loss would only be in the paper. Moreover, the loss will get reduced if you factor in ₹200 premium received on selling the call option. So, the total loss on paper would be ₹800.

Covered Call Option Strategy Payoff Schedule
Stock Price on ExpiryNet Payoff(₹)
[(Stock Price - BEP) x 100]
BEP=48
MAX PROFIT= 700
45-300
46-200
47-100
48-0
49100
50200
51300
52400
53500
54600
55700
56700
57700
58700
covered call strategy example nifty

Market View - Bullish

When you are expecting a moderate rise in the price of the underlying or less volatility.

Actions

  • Buy Underlying
  • Sell OTM Call Option

Let's assume you own TCS Shares and your view is that its price will rise in the near future. You will Sell OTM Call Option of TCS at a price, where you target to sell your shares. You will receive premium amount for selling the Call option and the premium is your income.

Breakeven Point

Purchase Price of Underlying- Premium Recieved

Risk Profile of Covered Call

Unlimited

Maximum loss is unlimited and depends on by how much the price of the underlying falls. Loss happens when price of underlying goes below the purchase price of underlying.

Loss = (Purchase Price of Underlying - Price of Underlying) + Premium Received

Reward Profile of Covered Call

Limited

You earn premium for selling a call. Maximum profit happens when purchase price of underlying moves above the strike price of Call Option.

Max Profit= [Call Strike Price - Stock Price Paid] + Premium Received

Max Profit Scenario of Covered Call

Underlying rises to the level of the higher strike or above.

Max Loss Scenario of Covered Call

Underlying below the premium received

Advantage of Covered Call

It helps you generate income from your holdings. Also allows you to benefit from 3 movements of your stocks: rise, sidewise and marginal fall.

Disadvantage of Covered Call

Unlimited risk for limited reward.

How to exit?

  • Exercise Call Option when strike price moves above stock price.
  • Wait for Option to expire and retain the premium received.
  • Buy Call Option and Sell underlying.

Simillar Strategies

Bull Call Spread

Comments

No comments found. Be the first to post a comment.








Search Chittorgarh.com:

Download Our Mobile App

Android App iOS App