What is Covered Call?

Want to hear about a strategy that helps you earn from the capital already invested in the assets? Covered Call strategy could help you earn some extra income from the stock you own; let’s find out how?

What Is Covered Call?

A covered call is an options trading strategy where an investor sells call options on a stock they already own.  A covered call is an income-generating options strategy. You cover the options position by owning the underlying stock. The owned asset/share acts as a cover because you can deliver the shares if the call option buyer chooses to exercise it.

Covered Call Strategy 

In the covered call, you sell a call option on a stock you already own. Since you own the stock, you’re protected if the buyer exercises the option. The buyer exercises the option and buys the stock from the writer at the strike price when the option is in the money or expires above its strike price. The writer keeps the premium but misses out on the stock’s upside price movement. When the option is out-of-the-money, the option expires worthless, and the writer keeps both the premium and the stock.

When to Use Covered Call

Use covered call when you have a neutral view on the underlying with little likelihood of large gains or large losses or less volatility. It means it’s a good strategy for sideways movement in security; use it when you have a mildly Bullish market view and you expect the price of your holdings to rise moderately in the future.

Covered calls are not an optimal strategy if the underlying security has a high chance of large price swings. If the price rises higher than expected, the call writer would miss out on any profits above the strike price. If the price falls, the options writer could stand to lose the entire price of the security minus the initial premium.

Covered Call Strategy Payoffs

• Covered Call Maximum Gain Formula
  Maximum Profit = (Strike Price – Initial Stock Price) + Option Premium Received
  
• Covered Call Maximum Loss Formula
  Maximum Loss Per Share = Initial Stock Price – Option Premium Received
  
• Break Even Point= Purchase Price of Underlying- Premium Received

Example of Covered Call Option

For example, an investor owns 100 shares of Tata Motors. Investor likes its long-term prospects, but still they feel the stock will likely trade relatively flat in the shorter term, its current price is of Rs1000.

If they sell a call option on Tata Motors with a strike price of Rs 1050, they earn the premium from the option sale but cap their upside on the stock to Rs 1050. Assume the premium they receive for writing a call option is Rs 20 (Rs. 20 per contract or 100 shares i.e Rs 20*100= 2000). 

One of two scenarios will play out:

1. Tata Motors shares trade below or equal to Rs 1050 strike price: The option will expire worthless and the investor will keep the premium from the option. In this case, they have successfully outperformed the stock by using the covered call strategy. They still own the stock but have an extra Rs 2000 in their pocket.
   
2. Tata Motors shares rise above Rs 1050: The option is exercised, and the upside in the stock is capped at Rs 1050. If the price goes above Rs 1070 (strike price plus premium), the call seller starts to lose out on upside potential. However, if they planned to sell at 1050, writing the call option gives them an extra Rs 20 per share.

Advantages of Covered Call

• Immediate Income: As you short a call you receive a premium which is an income without having to sell your stock.
• Price Locked In:  In a covered call your view is of a moderate appreciation in stock price, so a covered call ensures you sell if your target price is reached. This may be like a limit order, a type of instruction you can give your brokerage that requires an asset to be sold if a certain price is reached. But in the case of a covered call, you also get a premium.
• Create Profit: This strategy creates profit in the sideways market.
• Get downside protection: By holding the securities until a certain price is reached, it’s possible your security’s price could drop in value while you wait. The premium you receive from the covered call can help offset the drop in the security price.
• Relatively low-risk strategy: Covered call is a relatively low-risk strategy as the seller owns the underlying, in case the buyer wants to exercise the option. Comparatively, naked call writers have unlimited loss potential if the underlying price rises significantly.

Disadvantages of Covered Call

• Sensitivity: Covered calls are sensitive to earnings announcements as sudden price movements can happen.
• Limited profit: The covered call limits the investor’s potential upside profit.
• Opportunity loss: Writing covered calls limits the maximum profit for the stock position in exchange for a small premium. If the stock price increases significantly, the investor could miss out on a lot of potential profit.
• Obligation to sell shares: The investor has an obligation to sell their shares at the strike price if the purchaser of the option decides to exercise it.
• Limited protection: The covered call may not offer much protection if the stock price drops. However, if the stock price drops, the premium received from selling the call option can offset some of the loss. If the stock price drops more than the premium amount, the covered call strategy will start to make losses. 

Conclusion

A covered call is an options trading strategy that allows an investor to profit from small price fluctuations. A covered call strategy involves writing call options against a stock the investor owns to generate income and/or hedge risk. Sellers of covered call options are obligated to deliver shares to the purchaser if they decide to exercise the option. Avoid writing covered calls over a period of earnings announcements because sudden price changes can occur. When using a covered call strategy, there is a possibility of limited gain and huge loss if the underlying price drops significantly. Covered calls have pros and cons, and an investor should understand every aspect of them before deciding to take a position.

Frequently Asked Questions (FAQs)