Covered Call Option Trading Strategy Explained

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

Covered Call Options Strategy

Strategy Level	Advance
Instruments Traded	Call + Underlying
Number of Positions	2
Market View	Bullish
Risk Profile	Unlimited
Reward Profile	Limited
Breakeven Point	Purchase 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 Rs 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 Rs 2. Since you are selling an option, you will receive Rs 2 X 100= Rs 200.

ABC Stock Price	Rs 50
Short Call Option Strike Price	Rs 55
Option Lot Size	100
Premium Received	Rs 200
Break Even Point (Purchase Price of Underlying - Premium Received)	Rs 48

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

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

Now let's discuss about the possible scenarios:

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

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

Scenario 2: Stock price of ABC falls to Rs 40

Your holding will lose (Rs 50-Rs 40= Rs 10) X 100= Rs 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 Rs 200 premium received on selling the call option. So, the total loss on paper would be Rs 800.

**Covered Call Option Strategy Payoff Schedule**
Stock Price on Expiry	Net Payoff(Rs ) [(Stock Price - BEP) x 100] BEP=48 MAX PROFIT= 700
45	-300
46	-200
47	-100
48	-0
49	100
50	200
51	300
52	400
53	500
54	600
55	700
56	700
57	700
58	700

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

Breakeven Point

Purchase Price of Underlying- Premium Recieved

Risk Profile of Covered Call

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

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

3 Comments

3. Rehman

| Link|September 24, 2021 9:23:26 PMReply

If spot price closes above 5700 then sell call is at loss correct? But your explanation is showing max 700 loss only even for 5800, 5900 price close.... pls clarify

2. Anil Khatri

| Link|July 12, 2021 10:40:13 AMReply

For Covered call, I need to understand the following
1) Do we need to pledge the shares of the underline to get margin benefit?
2) With new Sebi rules on Margin, even after pledging - we need to keep 50% cash as margin for covered call - am I Right?
3) To unpledge the shares on Zerodha, it take T+1, so on Expiry, if the Strike in on ITM, how can you give Delivery as shares would be Pledged. If we don't Pledge, then full margin has to be given, then the return on investment with margin being blocked, will be very less.
Please help me understand this better, thanks

2.1. B S Rana

| Link|July 23, 2021 9:51:01 AM

I am also seeking answer to these queries, .I think it is prudent to square of the position well before the expiry. Only 50% margin requirement is allowed out of pledged shares. 50% has` carrying overnight position. Zerodha increases margin from Wednesday of week of expiry. So winding up before that is wise.

1. Vikas Lohia

| Link|January 17, 2021 9:47:04 PMReply

I didn't understand this explanation. I will ask my doubt with an example. Please, someone, clear it.

Suppose, I have 250 Shares of Bajaj Finance which is also its F&O lot. My buying price is 4500 and CMP is 5000. I sold next month's far OTM call of strike 5500 @ 250. So I got a premium of 250*250= 62500. My plan is to square off this position @ 100 or below next month, due to premium decay, so I will get the profit of ~150 and keep my holding intact.

But, instead, the price shoots to 6000 and my option is now trading at 500. So now I'm at a loss of 250*250=62500. Now, what should I do? Should I exercise the option because I have equity shares? Do normally people exercise options? If I exercise than will I get my money @5500 which is my strike price or @6000 which is CMP?

Please clear my doubt. Thnx

1.1. Manas Konar

| Link|June 12, 2021 5:10:14 PM

You will get the strike price of bajajfinance ie 5500.

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