Covered call

Covered call

Post By - Laxmi Mahera
Review By : Rohan Sharma
Updated on : October 25, 2021

Basics Concepts - Covered Call

Description - Covered Call

The Covered Call is the most basic of income strategies, yet it is also highly effective and can be used by novices and experts alike.
The concept is that in owning the stock, you then sell an Out of the Money call option on a monthly basis as a means of collecting rent (or a dividend) while you own the stock.
If the stock rises above the call strike, you’ll be exercised, and the stock will be sold . . . but you make a profit anyway.
If the stock remains static, then you’re better off because you collected the call premium.
If the stock falls, you have the cushion of the call premium you collected.

Context - Covered Call

Outlook

With a Covered Call, your outlook is neutral to bullish. You expect a steady rise.

Rationale

To buy (or own) a stock for the medium or long term with the aim of capturing monthly income by selling calls every month.
This is like collecting rent for holding the stock and will have the effect of lowering your cost basis of holding the stock.

Net Position

This is a net debit transaction because you are paying for the stock and only taking in a small premium for the sold call options. You can increase your yield by purchasing the stock on margin, thereby doubling your yield if you use 50% margin.
Your maximum risk is the price you paid for the stock less the premium you received for the call.

Effect of Time Decay

Time decay is helpful to your trade here because it should erode the value of the call you sold.
Provided that the stock does not hit the strike price at expiration, you will be able to retain the entire option premium for the trade, thus reducing your original cost of buying the share.

Time Period to Trade

Sell the calls on a monthly basis.

Breakeven = (Stock price paid – call premium)

Steps to Trading a Covered Call

Steps In

Try to ensure that the trend is upward or range bound and identify a clear area of support.

Steps Out

Manage your position according to the rules defined in your Trading Plan.
If the stock closes above the strike at expiration, you will be exercised. You will deliver the stock at the strike price, whilst having profited from both the option premium you received and the uplift in stock price to reach the strike price. Exercise is automatic.
If the stock remains below the strike but above your stop loss, let the call expire worthless and keep the entire premium. If you like, you can then write another call for the following month.
If the stock falls below your stop loss, then either sell the stock (if you’re approved for naked call writing) or reverse the entire position (the call will be cheap to buy back).

Exiting the trade

Exiting the Position

If the share rises above the strike price, you will be exercised and therefore make a profit.
If the share stays below the strike price, you will have successfully reduced your cost of entry because the premium you took in will offset the price you paid for the stock.

Mitigating a Loss

Either sell the share or sell the share and buy back the option you sold.

Advantages and Disadvantages

Advantages

Generate monthly income.
Lower risk than simply owning the stock.
Can profit from range bound stocks.

Disadvantages

Some traders consider this to be an expensive strategy in terms of cash outlay.
Capped upside if the stock rises.
Uncapped downside if the stock falls, cushioned only by the call premium received.

Share this Content

Derivatives Analysis

Advanced Option Strategy