About Covered Call – Options Trading Strategy

The world of options trading moves fast, and one of the major strategies for investors comprises covered calls. Investors are looking to make more money and, at the same time, control their risks in the stock market. On having a stock and selling a call option on the same, investors derive a unique blend of benefits and factors to consider. The mastery of the concept of covered call will help you add variety to your portfolio and take full advantage of various market scenarios.

A covered call pertains to when the investor has some stock and sells a call option on that particular stock. The selling of the call option provides a premium-a desirable regular source of income. It even reduces the cost basis of the stock and provides partial hedging against loss. Remember, though, this strategy is going to limit your gains in case the stock price outperforms the strike price set on the call option.

Key Takeaways

• A covered call means an option trading strategy whereby investor owns stock long and sells a call based on the same stock.
• Advantages of covered calls mainly include receiving extra income via premiums, reduction in the cost basis of the stock, and offering some downside protection.
• Covered calls are an excellent strategy for the investor who is either bullish or neutral on the stock in consideration, as they help to enhance returns in either a flat or slightly rising market.
• The major risks associated with covered calls are limited profit potential, and missed gains in the event of the stock price surging to rise above the strike price of the call option.
• It is important to have a proper understanding of the concept of a covered call, the possible risks associated with it, and the potential benefits as an investor uses it within their overall investment portfolio.

Table Of Contents

What is a Covered Call: Basic Ideas and Foundations

The covered call is a strategy by which investors can gain supplementary income. Investors possess a stock and sell calls over it. By so doing, they get the opportunity to acquire a premium on the call option.

Components of a Covered Call Strategy

The major components of a covered call strategy are:

• Having a long position in the stock
• Sell a call – on the same stock
• Agree to sell the stock at the strike price in case the call is exercised.
• Getting the premium from selling the call option

How Covered Calls Generate Income

The main source of income from covered calls is the premium. This is the cost that the buyer pays when buying an option to purchase a common stock at a pre-defined strike price before a certain expiration date. This premium can yield a respectable and consistent return, even when the price of the stock does not experience large fluctuations.

Key Terms in Covered Call Trading

First, to get covered call trading, you have to know some key terms.

• Call options: These refer to those types of contracts that enable the holder to buy the stock during a specific time period at a certain strike price.
• Strike Price: The price at which the call option is exercised in buying the stock.
• Premium: An option contract is valued by the amount that the buyer pays for the call.
• Underlying stock: This refers to a stock on which the call option bases its foundation and is exercisable with the option.
• Expiration date: It is the date at which the call option contract actually expires and cannot be used anymore.

Benefits and Advantages of Covered Call Options

The use of covered call options in the investor’s portfolio may result in a lot of benefits accruing from them. It earns extra income from selling call options on stocks that you own. This can lower the cost of the stock, thus being good for those people who want to increase their returns.

Besides, covered calls offer a protection against loss in the stock market. The premium received from the option sale mitigates possible losses. This is worth trying in periods of unrest or uncertainty in the market, in which one is sure of some kind of security.

These options might also be used to optimize your portfolio. Options boost income and cannot harm your returns either. Careful selection, by appropriately choosing the strike prices and expiration dates, will make sure that this strategy fits your goals of investment and your risk level.

Covered Call Example with Nifty 50 at 23,500

Position: Own 75 units of Nifty 50 at 23,500.

Strategy: Sell 1 call option with:

Strike Price: 24,000

Premium: ₹200 per unit (₹15,000 total).

Outcomes

Nifty Below 24,000:

Call expires worthless.

Keep ₹15,000 premium as profit.

Nifty Above 24,000:

Call is exercised.

Sell at 24,000.

Profit = ₹500 × 75 (₹37,500) + ₹15,000 = ₹52,500.

Nifty Below 23,500:

Stock value drops.

Loss is reduced by ₹15,000 premium.

Max Profit: ₹52,500.

Max Loss: Unlimited (beyond ₹15,000 premium).

Breakeven: 23,300 (23,500 – ₹200).

FAQ

What is a covered call strategy?

A strategy of a covered call involves stock ownership and selling calls on the same. In this way, through option premiums, investors derive income. They still hold on to the stock.

What are the key ingredients of a covered call strategy?

The two big parts to a covered call strategy are: a) owning the stock, and b) selling call options against it.

How do covered calls generate income?

The profits realized from a covered call come from the premiums of the sale of calls. An investor receives a premium in the sale of a call option. That premium is the greatest amount of profit that they will realize.

What are some key terms to know related to the covered call trade?

Some of the important terms involved in covered call trading include strike price, expiration date, time value, and implied volatility. The strike price is the price at which the option will be exercised. The expiration date is the date on which the option expires. Time value pertains to the remaining time before the expiration. Implied volatility is a measure of the expected changes in the stock price.

What is the advantage of a covered call strategy?

Benefits of a covered call strategy include the following: 1) generating additional income from option premiums, 2) insurance against stock price decline, 3) reduction of the cost basis for the stock, and 4) enhancement of risk and return for an overall investment portfolio.

What are some of the risks associated with covered call strategies?

Some of the draw backs with covered call strategies include: 1) limited profit if the stock price goes up big, losing out on big gains in a bullish market, and 3) stock price drops below cost basis, even with premium received.