A covered call strategy is a popular options trading strategy that involves selling call options on an underlying asset that the investor already owns. The investor sells call options to generate an income stream, while the long position in the asset acts as a cover. This strategy is often employed by investors who have a neutral to slightly bullish outlook on the underlying asset. In other words, they believe that the price of the asset will either remain stable or experience only minor price fluctuations in the near term.
In a covered call strategy, the most you can make is the money you get from selling the call options, along with any increase in the stock's price from where it is now to the strike price. But the most you can lose is the price you paid for the stock minus the money you got from selling the call options. It is a conservative strategy suitable for investors who want to generate additional income from their existing investment without taking on excessive risks.
How the covered call strategy works
1. Start with stock ownership: Let us consider that you own 100 shares of XYZ Ltd., a stock trading at Rs. 1,000 per share.
2. Select specific call options: You decide to sell call options for XYZ Ltd. with a strike price of Rs. 1,100 and an expiration date in one month.
3. Sell the call options: You sell these call options to another investor, agreeing to potentially sell your 100 shares of XYZ Ltd. at Rs. 1,100 each if they choose to exercise the options.
4. Receive a premium: The investor pays you a premium, say Rs. 50 per option, for the right to buy your shares at Rs. 1,100. You receive Rs. 5,000 (Rs. 50 x 100 shares) as your premium.
5. Possible outcomes:
- If the price of XYZ Ltd. stays below Rs. 1,100 until the options expire, the options become worthless, but you keep the Rs. 5,000 premium.
- If the stock price rises above Rs. 1,100 and the options get exercised, you sell your shares for Rs. 1,100 each (total Rs. 110,000), and you keep the Rs. 5,000 premium.
- If the stock price rises but stays below Rs. 1,100, you benefit from the premium income (Rs. 5,000) and any increase in the stock's price up to Rs. 1,100.
6. Managing the strategy: You have the flexibility to decide whether to buy back the options before they expire or allow them to be exercised based on your expectations for XYZ Ltd.'s price.
In this example, the covered call strategy allows you to generate income (Rs. 5,000 premium) while possibly benefiting from modest stock price increases, all while retaining ownership of your shares in the Indian stock market.
Features of the covered call strategy
The covered call strategy comes with several distinct features that make it an attractive choice for investors, especially those who are new to the stock market:
- Low-risk approach: When compared to many other options strategies, covered calls are generally considered to be a low-risk approach. This is primarily because the strategy involves owning the underlying stock, providing a level of safety and stability. The fact that you hold the stock acts as a safety net.
- Income generation: A core objective of the covered call strategy is income generation. By selling call options, investors can earn a premium. This premium is essentially a payment from those who buy the options, and it adds to your income stream. It is like getting paid for being open to selling your stock at a specific price in the future.
- Profit potential: The maximum profit potential with a covered call is somewhat limited but can still be attractive. Your profit consists of two parts: the premium you receive when you sell the call options and any potential gain in the stock's price from its current level to the strike price. While the upside is limited by the strike price, it can still provide a decent return.
- Suitable for stable stocks: Covered calls work exceptionally well with stocks that have stable prices and do not experience significant volatility. This makes them an excellent choice for investors who believe in the long-term stability of a particular stock but want to enhance their returns through regular income generation.
Benefits of the covered call strategy
- Downside protection: The covered call strategy provides a cushion against potential losses if the price of the underlying stock decreases. The premium received from selling the call options partially offsets any decline in the stock's value. This downside protection is crucial for conservative investors who want to limit their exposure to market volatility.
- Strategic leverage: Covered calls are a strategic approach to managing investments. They are often employed by investors who plan to hold an underlying asset for an extended period but do not anticipate significant price increases in the near term. This strategy enables them to maximise their returns by generating income from their holdings without taking on additional risk.
- Reduced volatility risk: Covered calls are particularly well suited for stocks with stable prices that are not prone to extreme volatility. By implementing this strategy with such stocks, investors can reduce their exposure to market turbulence and unpredictable price swings, making it an ideal choice for risk-averse individuals.
- Flexibility: Covered calls can be customised to match an investor's risk tolerance, investment goals, and market outlook. Investors have the flexibility to choose strike prices, contract durations, and the number of call options they sell, allowing them to tailor the strategy to their specific needs.
Conclusion
The covered call strategy is a conservative yet effective approach to generate income from existing holdings while maintaining some degree of downside protection. It is a strategy that allows investors to leverage their belief in the stability of an underlying asset and benefit from both premium income and potential price appreciation. However, it is essential to understand the potential trade-offs, including the risk of potentially capping gains if the asset's price rises significantly.
