COVERED CALL

COVERED CALL

You own shares in a company which you feel may rise but not much in the near term (or at best stay sideways). You would still like to earn an income from the shares. The covered call is a strategy in which an investor Sells a Call option on a stock he owns (netting him a premium). The Call Option which is sold in usually an OTM Call. The Call would not get exercised unless the stock price increases above the strike price. Till then the investor in the stock (Call seller) can retain the Premium with him. This becomes his income from the stock. This strategy is usually adopted by a stock owner who is Neutral to moderately Bullish about the stock.

An investor buys a stock or owns a stock which he feel is good for medium to long term but is neutral or bearish for the near term. At the same time, the investor does not mind exiting the stock at a certain price (target price). The investor can sell a Call Option at the strike price at which he would be fine exiting the stock (OTM strike). By selling the Call Option the investor earns a Premium. Now the position of the investor is that of a Call Seller who owns the underlying stock. If the stock price stays at or below the strike price, the Call Buyer (refer to Strategy 1) will not exercise the Call. The Premium is retained by the investor.

In case the stock price goes above the strike price, the Call buyer who has the right to buy the stock at the strike price will exercise the Call option. The Call seller (the investor) who has to sell the stock to the Call buyer, will sell the stock at the strike price. This was the price which the Call seller (the investor) was anyway interested in exiting the stock and now exits at that price. So besides the strike price which was the target price for selling the stock, the Call seller (investor) also earns the Premium which becomes an additional gain for him. This strategy is called as a Covered Call strategy because the Call sold is backed by a stock owned by the Call Seller (investor). The income increases as the stock rises, but gets capped after the stock reaches the strike price. Let us see an example to understand the Covered Call strategy.

You own shares in a company which you feel will not rise in the near term. You would like to
When  to   Use:  This   is   often				Example
employed when an investor has a
earn an income from the stock. The covered call is a strategy in which an investor Sells a Call
short-term	neutral	to		Mr.  A  bought	XYZ  Ltd.  for  Rs	3850  and
				simultaneously sells a Call option at an strike
optimonderatelyonstockbullishheownsview.TheonCalltheOption which is sold in usually an OTM Call. Selling the
stock  he  holds.  He  takes  a  short				price of Rs 4000. Which means Mr. A does not
				think that the price of XYZ Ltd. will rise above
Call option enables the investor to earn an income by way of the Premium received.  The Call
position   on   the   Call   option   to				Rs. 4000. However, incase it rises above Rs.
generate  income  from  the  option
would not get exercised unless the stock price increases above the strike price. Till then the
premium.				4000, Mr. A does not mind getting exercised
				at that price and exiting the stock at Rs. 4000
investor can keep the Premium with him which becomes his income. This strategy is usually
Since   the   stock   is   purchased				(TARGET SELL PRICE = 3.90% return on the
				stock  purchase  price) .  Mr.  A  receives  a
adopted by a stock owner who is Neutral or Bearish about the stock. At the same time, he does
simultaneously with writing (selling)				premium of Rs 80 for selling the Call. Thus
the Call, the strategy is commonly
not mind exiting the stock at a certain pricenet.TheoutflowinvestortocanMrsell.A Callis Options at the strike price
referred to as “buy-write”.				(Rs. 3850 – Rs. 80) = Rs. 3770. He reduces
at which he would be fine with exiting the stock. By selling the Call Option the investor earns a
Risk:  If  the  Stock  Price  falls  to				the cost of buying the stock by this strategy.
Premium. Not he position of the investor is that of a Call Seller (refer to Strategy 2), who owns
zero, the investor loses the entire				If the stock price stays at or below Rs. 4000,
value of the	Stock but retains	the		Call option will not get exercised and Mr.
the underlying stock.  If the stock price
			stheays be ow the strike price the Call Buyer (Refer to
premium, since the Call will not be				A can retain the Rs. 80 premium, which is an
stratexegyrcised1) will againstnotexercisehimthe. CallSo. The Premium is retained by the Call seller. This is an
maximum risk = Stock Price Paid –				extra income.
income for him. In case the stock price goes above the strike price, the Call buyer who has the
Call Premium				If the stock price goes above Rs 4000, the
				Call  option  will  get  exercised  by  the  Call
right to buy the stock at the strike price will exercise the Call option. The Call seller who has to
Upside  capped  at  the  Strike  price				buyer. The entire position will work like this :
sellplusthethestockPremiumtotheCallreceivedbuyer .willSo sellif the stock to the Call buyer at the strike price. This was
the  Stock  rises  beyond  the  Strike				interested in exiting the stock and now exits at that
the price which the Call seller was anyway
price the investor (Call seller) gives				Strategy : Buy Stock + Sell Call Option
up all the gains on the stock.
price. So besides the strike price which was the target price for selling the stock the Call seller
				Mr. A buys the	Market Price (Rs.)		3850
also earns the Premium which becomes an additional gain for him.
Reward:  Limited  to  (Call  Strike				stock XYZ Ltd.
Price – Stock Price paid) + Premium
received
Breakeven:  Stock  Price  paid  -				Call Options	Strike Price (Rs.)		4000
Premium Received
				Mr. A receives	Premium (Rs.)		80
					Break Even Point		3770
					(Rs.) (Stock Price
					paid - Premium
					Received)