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Covered Call

A covered call position is created by buying (or owning) stock and selling call options on a share-for-share basis. In the example, 100 shares are purchased (or owned) and one call is sold. In return for the call premium received, which provides income in sideways markets and limited protection in declining markets, the investor is giving up profit potential above the strike price of the call. The call premium increases income in neutral markets, but the seller of a call assumes the obligation of selling the stock at the strike price at any time until the expiration date.

In a covered call position, the risk of loss is on the downside. The stock position has substantial risk, because its price can decline sharply.

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Mr. G owns Reliance Shares and expects the price to rise in the near future. Mr. G is entitled to receive dividends for the shares he hold in cash market.

Covered Call Strategy involves selling of OTM Call Option of the same underlying asset. The OTM Call Option Strike Price will generally be the price, where Mr. G will look to get out of the stock. He will receive premium amount from writing the Call option.

Risk: Mr. G will incur losses on his short position when the stock moves beyond the strike price of the call written. This strategy is generally adopted by the people who are ‘Neutral or Moderately Bullish’ on the underlying asset.

Reward: Mr. G will make profits when the stock price shoots up and pockets the premium which he received from shorting the Call Option. If it comes down then he is willing to exit at a point, the exit point is where Mr. G has shorted the Call Option.

Breakeven Point is Stock price minus call premium received

Action

Buy Shares in Cash/Future

Sell OTM Call Option

Example

RIL is trading around Rs 2240 levels. Lot size of RIL Option is 505. Mr. G is bullish in nature and buys one lot of RIL @ Rs 2240 from the market. He also shorts one 2300 strike Call Option for a premium of Rs. 80.

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Breakeven Point Breakeven Point is 2,160 (2240-80).

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Result 1: If RIL closes at Rs. 2240, Mr. G will received from call writing it i.e. Rs.40,400 (80*505).

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Result 2: If RIL closes at Rs. 2300, Mr. G will make a profit on his long position in future market and profit on his short call. His net payoff will be Rs. 70,700.

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Result 3: If RIL closes at Rs. 2100, Mr. G will make a loss on his long position in future market and profit on his short call. His net loss will be Rs.30,300.