🎯 Objective:
The Covered Call strategy is primarily used for Income Generation, as it allows the investor to generate additional premium income from their long stock positions. It is also a Neutral to Bullish strategy, meaning it performs best when the stock price is expected to either remain stable or rise moderately. It works well in situations where you expect low volatility in the market, as you are selling the right to someone else to buy your stock at a particular price (strike price).
📊 Market View:
This strategy is generally implemented with a Bullish or Neutral market outlook. The expectation is that the underlying stock will not rise dramatically above the strike price of the option. If the stock price increases sharply beyond the strike price, the call option buyer may exercise the option, and you’ll be forced to sell your stock at the strike price, capping your potential upside. Covered Calls can also work well in low volatility (Low IV) environments.
💬 When to Use:
You should consider using the Covered Call strategy when the market is neutral or mildly bullish. In addition, if you expect minimal price movement or mild upward movement in the underlying asset, this strategy can help you generate income. High volatility might not be the best scenario for this strategy, as the price movements may exceed the strike price, leading to potential missed opportunities on the upside.
💼 Instruments Used:
Covered calls can be executed on Index Options or Stock Options. The most common instruments used are individual stocks or ETFs for a more diversified portfolio. With index options, like Nifty or Bank Nifty, traders may sell covered calls against their holdings in these indices.
🧪 Risk Profile:
The risk profile of a Covered Call strategy is generally Limited. The risk is tied to the underlying stock position (if the stock falls sharply, you incur losses on the stock), but the call premium received acts as a cushion, reducing the overall loss. Your upside potential is limited to the strike price of the sold call option.
💰 Capital Required:
To implement the Covered Call strategy, you need to own the underlying asset, such as a stock or index ETF. The capital required is the cost of purchasing the underlying asset. For instance, if you’re buying 100 shares of a stock, you will need the capital for 100 shares. Additionally, the margin required for selling the call option is typically a small percentage of the value of the underlying asset.
🔍 Setup:
Entry: Example: Assume you’re holding 100 shares of Nifty ETF, and the current price of the Nifty ETF is ₹18,000. You may decide to sell a ₹18,500 strike price call option with an expiry of 1 month.
Strike Selection: The strike price is chosen slightly above the current market price, at a level where you believe the stock will not surpass in the near term.
Quantity: You sell one call option contract for every 100 shares you own.
Expiry: The expiry should align with your outlook for the stock and market conditions. Typically, monthly or weekly options are used.
How Covered Calls Work and How to Use Them
Description:
A Covered Call is a simple options strategy where you own the underlying asset (usually stocks or ETFs) and sell a call option on that asset. The idea is that you generate premium income from selling the call option while holding onto the underlying asset. The premium you receive from selling the option acts as income, which lowers your breakeven point on the stock.
Understanding Covered Calls:
The concept of a Covered Call is relatively simple. You sell a call option on a stock you already own, and in return, you receive the premium for that call option. If the stock price rises above the strike price of the call option, your stock may be “called away” (sold at the strike price). If the stock price stays below the strike price, you keep both your stock and the premium income.
Steps to Trading with ATM, OTM, ITM:
ATM (At the Money): Choose a strike price close to the current market price. This provides higher premium income but limits your upside potential.
OTM (Out of the Money): The strike price is above the current market price. This gives more room for the stock to appreciate before your shares are called away. This is often preferred for income generation.
ITM (In the Money): The strike price is below the current market price. This strategy provides the highest premium, but there is a higher risk that your shares will be called away.
Steps In and Steps Out:
Steps In: Buy the underlying asset (stock or ETF), and then sell a call option at a chosen strike price (ATM, OTM, or ITM).
Steps Out: If the option is exercised (the stock goes above the strike price), you sell your stock at the strike price and keep the premium. If the option expires worthless, you keep both your stock and the premium.
Context:
Outlook: Covered Calls are typically used when you expect the stock to be stable or moderately bullish.
Rationale: The rationale is to generate income through premium selling while holding on to your underlying asset.
Net Position: A combination of holding the stock and being short the call option.
Effect of Time Decay: As options approach expiration, their time value decays, benefiting the seller of the option (in this case, you).
Selecting the Option:
Choose a strike price above the current price to minimize the risk of being assigned (OTM).
The closer the strike price is to the current market price, the higher the premium you’ll receive but the higher the chances of being called away.
Risk and Reward:
Risk: The main risk is a sharp decline in the price of the underlying asset, which would result in a loss on the stock position. However, the premium received from selling the call helps offset this loss.
Reward: The maximum reward is the premium received plus the potential appreciation of the underlying asset up to the strike price.
Advantages and Disadvantages:
Advantages:
Generates additional income on long positions.
Limits downside risk due to the premium income received.
Simple strategy that can be used in range-bound or mildly bullish markets.
Disadvantages:
Capped profit potential as the stock can only rise to the strike price.
Risk of losing the underlying stock if it appreciates past the strike price.
Potential loss if the stock falls significantly below the purchase price.
Exiting the Trade:
Early Exits: If the stock price moves sharply, you may decide to exit early by buying back the call option before expiry.
Rollovers: If the stock is near the strike price and you want to maintain the position, you can roll the call option by buying back the current call and selling another call option with a later expiry or different strike price.
Maximum Profit and Maximum Loss:
Maximum Profit: The maximum profit is the strike price of the sold call plus the premium received.
Maximum Loss: The maximum loss is the amount you paid for the stock minus the premium received (if the stock goes to zero).
Is this Strategy Profitable?:
Yes, this can be a profitable strategy in stable or mildly bullish markets, as it allows you to generate income on a stock that you already own.
Is this Strategy Risky?:
This strategy is relatively low-risk compared to other options strategies. The main risk is a significant drop in the underlying stock’s price, but the premium income provides a buffer against this.
💡 Example:
Let’s assume you own 100 shares of Nifty ETF at ₹18,000. You sell a ₹18,500 strike call option expiring in 1 month for a premium of ₹200.
If the Nifty ETF rises to ₹18,500 or higher, your shares will be called away, and you make ₹18,500 from the sale of the stock plus ₹200 from the option premium.
If the price remains below ₹18,500, you keep both your shares and the premium.
📉 Payoff Diagram:
Max Profit: ₹18,500 (strike price) + ₹200 (premium received).
Max Loss: ₹18,000 (stock price) – ₹200 (premium received) = ₹17,800.
Break-even Point: ₹18,000 – ₹200 = ₹17,800.
🛠️ Adjustments:
Early Exits: If the stock rises above the strike price and you want to lock in profits or avoid the stock being called away, you can buy back the call option.
Rollovers: If the stock price increases and you don’t want to lose your position, you can roll over to a new call option with a higher strike price.
🧾 Tax Implications:
Short-Term Capital Gains: The premium income from selling the call option is considered short-term capital gains if the option expires in less than 12 months.
Long-Term Capital Gains: The underlying asset may be subject to long-term capital gains tax if held for over a year.
Dividend Taxation: If your underlying stock pays a dividend, this is also subject to taxation.
The Bottom Line:
The Covered Call strategy is an effective income-generating strategy for investors holding long positions in stocks. It works well in stable or slightly bullish markets but limits potential upside. While it’s relatively low-risk due to the premium income providing a cushion, it does cap profits if the stock price rises significantly. Therefore, it’s best suited for investors who are willing to trade off some upside in exchange for consistent income generation.
