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Covered Call Strategy for Options Trading

01 Sep 2023

Introduction:

Suppose you own a specific quantity of shares of a company. You know that the price of your stock may rise in the long term, but not much will happen in the short term. However, you still want to earn an income from your shares in the short term. So, what options do you have?

You can use a Covered CALL Strategy in such a situation. It allows you to make potential income from the stocks you already own. Doesn’t this sound exciting?

Continue reading to learn in detail about the covered CALL strategy and how it can help you earn profit from the shares you already own but without selling them.

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What is a Covered CALL strategy?

A covered CALL is a strategy where you sell a CALL option against the underlying securities (such as equity shares) you already own. By doing so, you can receive a premium from the CALL option buyer and make some income from the idle-lying shares in your portfolio.

The covered CALL strategy aims to generate profit from the premium received from the sale of the CALL option on the shares in your portfolio. You can make additional gains if the price of your shares (against which you’ve issued the CALL option) remains within the strike price (at which you’ve sold the CALL option).

However, using this strategy carries a fair bit of risk. When you sell a CALL option, it gives the buyer the right (but not the obligation) to purchase all your stocks at a pre-determined strike price on or before the expiry date. So, if the value of your shares rises above the strike price, you may have to sell them to the buyer of your CALL option. Although you still earn profit from the CALL option premium, you won’t be able to gain from the potential price appreciation of your shares.

Understanding Covered CALL strategy with an example

Now, let’s understand how the covered CALL strategy works with the help of an example. Suppose you own 1000 shares of a company XYZ, and they are currently trading for Rs. 120 each. You feel that the value of your shares will go up to Rs. 200 in the long term.

However, you're not expecting much upsurge in the near term, so you decide to use the covered CALL strategy to make some additional income. So, you sell a CALL option contract against your shares with a strike price of Rs. 150 and for Rs. 10 per share premium. This way, you can earn up to Rs. 10,000.

Now, there are three situations possible:

Situation 1 – The price of the XYZ shares remains below the strike price at expiry

In this situation, whether you suffer a loss or profit depends upon the final price of the share. If the price of your shares remains within Rs. 110, you will still make a profit as your loss will be offset by the premium the CALL option buyer paid you. However, you will incur a loss if the share price falls beyond Rs. 110 per share. However, you get to keep both your premium and your shares.

Situation 2 – The price of the XYZ shares stays at the strike price on expiry

In such a situation, it’s unlikely that the buyer of your CALL option will exercise his right to buy shares from you. Thus, you will make a profit equal to the premium amount you’ve received from the buyer of your CALL option, i.e., Rs. 10,000. And you get to keep your shares as well.

Situation 3 – The price of the XYZ shares rises above the strike price at expiry

In such a situation, it’s most likely that the buyer of your CALL option will exercise his right to buy shares at the strike price from you. However, this can happen if the share price moves above Rs. 160 per share. In such a case, you will keep the profit earned in the premium but may have to forfeit your shares and the potential gains resulting from future price appreciation.

The bottom line

Hopefully, now you understand what a covered CALL strategy is and how to use it to make income from your shares. However, do not forget to consider the risks associated with this strategy before making the move. If you need a Demat account for stock market investing, you can turn to Motilal Oswal.

 

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