WHAT IS COVERED CALL STRATEGY?

 

Covered call strategy: a comprehensive guide

 

   The covered call strategy is a popular options trading technique, particularly among conservative investors seeking to generate additional income from their portfolio. By selling call options on an underlying asset they already own, investors can potentially enhance their returns. This strategy, while relatively straightforward, carries risks and rewards that must be thoroughly understood before implementation.

 

   This detailed explanation will cover the basics of the covered call strategy, its mechanics, advantages, disadvantages, potential use cases, and examples to give you a solid grasp of how it works.

 

1. What is a Covered Call?

 

A covered call is a two-part strategy involving:

 

   Owning the underlying asset (stock, ETF, etc.).

   Selling a call option on that asset.

   In essence, when you sell a call option, you're giving the buyer the right (but not the obligation) to buy your shares at a predetermined price (the strike price) by a specific date (the expiration date). In return for selling this right, you collect a premium, which is the income from the trade. Since you already own the asset, your position is "covered." If the buyer decides to exercise the option, you can deliver the shares without needing to buy them on the open market.

 

2. How Does It Work?

 

Let’s break down the process with an example:

 

Step-by-Step process:

 

   Own shares of a stock. Suppose you own 100 shares of XYZ Corp. The stock is currently trading at Rs.50 per share.

 

   Sell a call option. You decide to sell a call option with a strike price of Rs.55 and an expiration date one month away. For selling this option, you collect a premium of Rs.2 per share (or Rs.200 total, since each options contract represents 100 shares).

 

Possible outcomes at expiration:

 

   Stock price remains below Rs.55 (option not exercised): If the stock price stays below Rs.55, the option buyer will not exercise their option because they can buy the stock cheaper on the open market. In this case, you keep the premium (Rs.200) and still own your 100 shares of XYZ Corp. The process can be repeated in the next period if desired.

 

   Stock price rises above Rs.55 (option exercised): If the stock price rises above Rs.55, the buyer is likely to exercise their option to purchase your shares at the strike price. You are obligated to sell your 100 shares at Rs.55, even if the stock is trading at, say, Rs.60. You still keep the premium (Rs.200), but you miss out on any gains above the Rs.55 strike price.

 

3. The goal of a covered call

 

   The primary goal of a covered call strategy is to generate income through the premiums received for selling call options. It can be especially useful for investors who believe the stock price will not rise significantly in the short term and want to earn extra income while holding the stock.

 

   In a flat or slightly bullish market, the strategy can be quite effective. The investor gets to keep the premium, and even if the stock rises, they benefit from the appreciation up to the strike price. However, in a rapidly rising market, this strategy caps the upside potential.

 

4. Key components of a covered call

 

There are several critical elements to consider when executing a covered call:

 

a) The underlying asset

 

   This strategy only works if you already own the stock or ETF on which you're writing the option. Stocks that are stable or have modest growth potential are generally preferred because extreme volatility could make the trade riskier.

 

b) The strike price

 

   The strike price is a central decision point. It represents the price at which you're willing to sell the stock if the option is exercised. A higher strike price offers more upside potential but will generate less premium. A lower strike price provides more premium but caps your upside at a lower level.

 

c) Expiration date

 

   Options contracts come with expiration dates. Short-term calls (less than a month) provide more frequent opportunities to collect premiums, while longer-term calls might give more stability to the strategy. However, longer expirations can leave you exposed for extended periods without being able to capitalize on other opportunities.

 

d) Premium

 

   The premium is the income you receive from selling the option. The premium is determined by various factors, including the stock price, strike price, volatility, and the time remaining until expiration. Higher volatility generally leads to higher premiums but also greater risk.

 

5. Advantages of a covered call strategy

a) Income generation

 

   Selling call options allows you to generate income regularly. If the market is stable or rising slowly, this can add significant cash flow to your portfolio.

 

b) Downside protection

   While the primary purpose of the strategy is to earn premiums, the income from selling calls can provide some protection in a falling market. The premium received reduces the effective cost basis of the stock. For example, if you receive Rs.200 in premiums, that offsets any potential losses in the stock value by Rs.200.

 

c) Flexibility

 

   The covered call strategy can be customized based on your market outlook. If you’re more bullish, you can sell calls with higher strike prices to retain more upside. If you’re neutral or bearish, you can sell calls with lower strike prices to maximize premiums.

 

d) Lower risk than naked calls

 

   In selling naked calls (without owning the underlying asset), you could face unlimited losses if the stock skyrockets. In a covered call, you own the shares, so you can always deliver the stock if the call is exercised.

 

6. Disadvantages and risks

 

a) Limited upside potential

 

   One of the significant drawbacks of the covered call strategy is that it caps your profit potential. If the stock surges beyond the strike price, your gains are limited to the strike price plus the premium, and you'll miss out on further appreciation.

 

b) Loss in a falling market

 

   While the premium received can offer some downside protection, it is limited. If the stock price falls significantly, the premium will not fully offset the losses in the underlying asset.

 

c) Call exercise risk

 

   If the stock price exceeds the strike price before expiration, your shares may be called away earlier than expected, which could prevent you from capitalizing on potential long-term appreciation.

 

d) Tax considerations

 

   Premiums earned from covered calls are considered short-term capital gains, which may be taxed at a higher rate than long-term gains. Moreover, if your shares are called away, you may have to pay taxes on the sale of the stock.

 

7. Ideal use cases for covered calls

 

a) Income-oriented investors

 

   Investors looking to generate consistent income from their holdings can use covered calls to earn regular premiums.

 

b) Neutral to slightly bullish outlook

 

   If you believe that the stock price will remain relatively stable or rise modestly, a covered call can be an effective way to enhance returns without giving up too much potential upside.

 

c) Long-term holders

 

   If you already own a stock and don’t plan to sell it in the near future, selling calls can be a way to earn income while holding.

 

d) Reducing portfolio volatility

 

   By receiving income from premiums, the overall volatility of your portfolio may be reduced.

 

8. Example of a covered call strategy

Let’s revisit the earlier example to clarify how a covered call works:

 

Initial position:  You own 100 shares of XYZ Corp at Rs.50 each.

 

Call option sold:  You sell one call option with a strike price of Rs.55, expiring in one month, and receive a Rs.2 premium (total of Rs.200).

 

Possible outcomes:

 

Scenario 1:  The stock stays below Rs.55. The option expires worthless, and you keep the Rs.200 premium. You still own your 100 shares.

 

Scenario 2:  The stock rises above Rs.55. The buyer exercises the option. You sell your 100 shares at Rs.55, keep the Rs.200 premium, and miss out on gains above Rs.55.

 

Conclusion

 

   The covered call strategy is a relatively conservative options trading approach that allows investors to generate additional income from stocks they already own. While it limits upside potential, it provides regular income and some downside protection, making it ideal for stable or slightly bullish markets. Like all strategies, it requires careful consideration of the risks and benefits before implementation.