Covered Call

A Covered Call is a widely popular options strategy whereby an investor holds a long position in an asset and sells call options on that same asset to generate an income stream. The investor’s long position in the asset is the “cover” since it means the seller can deliver the shares if the buyer of the call option chooses to exercise.

Setup:

Using Stocks –

• If the lot size of the stock is x; then Buy x amount of shares of that stock.
• Sell 1 lot of call options (So that the net quantity of call options sold is equal to the shares bought).

Using Futures –

• Buy 1 lot in futures long
• Sell 1 lot call options

The short call is usually At-The-Money (ATM) or Out-Of-The-Money (OTM)

Directional Assumption: Bullish

Ideal Implied Volatility Environment: High (The more premium we get for our call options, the better!)

Max Profit: Distance between stock price & short call + premium received from selling the call

How to Calculate Breakeven(s): Stock price – credit from the short call [It dynamics reduces as the credit dynamically increases over each contract’s end.]

Note: 

• The position limits the profit potential of the position as we are selling a call option.
• It is called “Covered Call” because the option seller is covered as he/she can deliver the shares needed if the contract gets exercised.
• This reduces the cost basis of the shares over time as when the share consolidates the option premium piles up as a profit.
• This also reduces the risk by the amount of option premium and in this way, the breakeven of the trade gets shifted to an even lower side each time we renew the contract.

Example:

Here is an example of a Covered Call setup –

1. Initial Stock Purchase:
   • Assume that you purchased the MRF stock at the current price of 140941.85.
2. Selling a Call Option:
   • You then sell a call option (which is a right to buy the stock at a specific price, called the strike price, by a certain date).
   • The option has a strike price of 150000, and you receive a premium (the price of the option) of 3129.75 for selling this option.
3. Potential Outcomes:
   • If the stock price is below 150000 at expiration:
     • The call option will not be exercised by the buyer, and you keep the premium of 3129.75.
     • Your total profit from the option would be 3129.75.
     • Your stock position would not change, although its value could be up or down based on the market price.
   • If the stock price is above 150000 at expiration:
     • The call option will likely be exercised.
     • You will have to sell the stock at 150000, no matter how high the market price has gone.
     • You still keep the premium of 3129.75.
     • Your profit from the stock sale would be 150000 – 140941.85 = 9058.15.
     • Your total profit from the option and the stock sale would be 9058.15 + 3129.75 = 12187.9.
4. Complete Calculation:
   • Total Investment: Price of MRF stock * number of shares bought.
   • Income from Call Premium: Premium received * number of options sold.
   • Total Return if Unexercised: Income from Call Premium.
   • Total Return if Exercised: (Strike Price – Purchase Price of Stock) * number of shares + Income from Call Premium.