Covered Call Strategy: Definition, Benefits, and Examples

Introduction

Imagine earning extra income from the stocks you own without selling them. Sounds intriguing, right? This is where the covered call strategy comes into play. It's a popular tactic among investors looking to enhance their returns while holding onto their beloved shares. But what exactly is a covered call strategy, and how can it benefit you? Let's dive in and explore this investment strategy in detail.

What is the Covered Call Strategy?

The covered call strategy is an options trading strategy that involves holding a long position in a stock while selling a call option on the same stock. This means you own the stock and simultaneously agree to sell it at a specified price (the strike price) if the option buyer decides to exercise the option.

In simpler terms, you have a stock and give someone else the right to buy it from you at a higher price. If the stock's price remains below that strike price, you keep the stock and the premium you received from selling the call option. If the stock's price goes above the strike price, you sell the stock at that price and will keep the premium.

Here's an example:

1. Owning shares: Imagine you have 100 shares of a company, each worth ₹2,000.

2. Selling a call option: You can sell a call option, which is like selling someone the right to buy your shares at a specific price, called the 'strike price'. Let’s say you set the strike price at ₹2,100 and sell the option for ₹50 per share.

3. Earning income: By selling this option, you get paid a fee, called a 'premium'. In this example, you earn ₹5,000 (₹50 per share x 100 shares).

4. Covered part: Since you own the shares, you are 'covered'. If the call option buyer wants to buy your shares at the strike price, you can easily give them the shares.

5. Two possible outcomes:

(i). If the stock price stays below the strike price (say ₹2,100), the buyer won’t want to buy your shares at a higher price. You keep your shares and the ₹5,000 premium.

(ii). If the stock price goes above the strike price (say ₹2,200), the buyer will want to buy your shares at ₹2,100. You sell your shares at ₹2,100 and keep the ₹5,000 premium.

This way, you earn extra money from the premium while holding your shares. If the stock price goes up a lot, you still can make money by selling the shares at the agreed price.

Features of Covered Call Strategy

1. Ownership of the underlying asset: You must own the stock you are writing the call option. This is why it’s called a 'covered' call: your obligation to sell the stock is covered by your ownership.
2. Income generation: By selling call options, you earn premiums, which provide additional income in addition to any profits the stock might pay.
3. Limited upside potential: Your profit is capped at the strike price plus the premium received. You won't benefit from that additional increase if the stock price rises significantly above the strike price.
4. Risk mitigation: The premium received offers some downside protection, reducing the overall loss if the stock price falls.

What are the Objectives for a Covered Call?

The primary objectives of using a covered call strategy include:

Income Generation

The primary goal of the covered call strategy is to generate income through the premiums received from selling call options. These premiums provide immediate income for investors. By consistently selling covered calls, investors can create a steady income stream in addition to any dividends earned from holding the stock.

Downside Protection

In addition to income generation, the covered call strategy also aims to offer downside protection. The premiums earned from selling call options help offset potential losses in the stock's value. As the stock price declines, these premiums act as a cushion, reducing the overall impact of the depreciation. Thus, the covered call strategy serves as a potential method for mitigating losses and providing a degree of downside protection for investors.

Benefits Of Covered Call

Here are the benefits of a covered call strategy:

Risk Reduction

The premiums received are a cushion against potential losses in the stock's value. If the stock price declines, these premiums can offset some of the losses, lessening the negative impact on the investor's portfolio.

Potential For High Returns

While the strategy may limit potential upside if the stock price rises, it still offers long-term capital appreciation as the investor continues to hold the stock, which may appreciate over time.

Customisation and Flexibility

Investors can customise their strategies by selecting various strike prices and expiration dates for the call options based on their market outlook and investment goals. This allows investors to match their risk tolerance, desired income levels, and specific stock holdings.

Portfolio Diversification

Incorporating covered calls into an investment portfolio adds diversification. By combining stock ownership with options trading, investors gain exposure to both the equity and options markets, enhancing the diversification of their investment approach.

Regular Cash Flow

The strategy can provide a stable and consistent cash flow from the received premiums. This is particularly beneficial for income-oriented investors who rely on periodic cash distributions to cover expenses and reinvest in other opportunities.

Disadvantages Of Covered Call

1. Limited upside: If the stock price surges significantly, your profits are capped at the strike price, and you miss out on potential gains above that level.
2. Obligation to sell: If the call option is exercised, you must sell your stock at the strike price, which might not be desirable if you have long-term plans for the stock.
3. Complexity: Understanding options trading requires certain financial knowledge and experience, which might be daunting for novice investors.
4. Management time: Regular monitoring and management of the positions are necessary to maximise returns and mitigate risks.