Knowledge Base

What is a Covered Call Strategy?

in Trading Strategies
Tags: covered calltrading strategy

Asset prices often move in unpredictable ways. You may often be certain of the long term prospects of such an asset, but the short term volatility may give you sleepless nights. A strategy that allows you to avoid this anxiety is called a Covered Call strategy.

Here’s how it works:

What is a Covered Call strategy

A Covered Call strategy is created by buying an asset (such as a stock, index, currency or commodity) and simultaneously selling an at-the-money (ATM) Call Option on it. Selling an Option is also called as ‘writing’ the contract.

A Call Option is a contract that allows an investor to buy a certain quantity of an asset at a fixed price (called strike price) on a future date (called expiry). This is in exchange for a small cost called a premium.

By writing the Call, you pass the privilege of buying the asset in future on to the Option buyer. In return, you earn the premium. ATM means that the strike price of the Call Option is the same as the current price of the underlying asset. So, it neither bears a loss nor makes a profit.

Application of a Covered Call strategy

A Covered Call strategy is deployed when you feel that an asset is going to appreciate in the long term, but expect the appreciation to follow a small, short-term depreciation. To benefit from the long-term expectations, you purchase the asset, but simultaneously sell a Call Option on it to earn a premium from the short-term depreciation.

Example of a Covered Call strategy

Let’s understand this through an example.

Let’s assume that a stock is trading at Rs 50 and is expected to appreciate to Rs 80 over the next twelve months. However, over the next three months, it is expected to depreciate. You will buy 100 shares of the stock and simultaneously write a Call Option on a similar value, with a strike price of Rs 50 itself (being an ATM call) and an expiry of three months. For this, you will get a hypothetical premium of Rs 2 per share or Rs 200 in all.

Payoff if the price depreciates

Let’s assume now, that the stock depreciates to Rs 45 over the next three months (as expected). The Option buyer will not exercise his Option because then he’ll be buying something that now costs Rs 45 at the higher rate of Rs 50. However, you, the Option writer, will still receive the premium for selling the Option. Thus, despite a fall of Rs 5 per share, you will make Rs 2 per share on the stock. Additionally, since the Option has not been utilized, you have not sold your stock to the Option buyer. You can continue holding it till it reaches your target of Rs 80 in the longer run and make a bigger profit.

Payoff if the price appreciates

If the stock appreciates to, say, Rs 54 after three months, the Option buyer will be tempted to exercise the Option because then, he’ll get a stock that now costs Rs 54 for Rs 50. Discounting the premium, this will save him Rs 2 per share. You, the Option writer, will be compelled to sell the stock at the old price of Rs 50, thus neutralizing your position. However, you will also earn the premium of Rs 2 per share. This will lead to a gain of Rs 2 per share. Of course, in this case, you will not be able to sell the stock later if it reaches Rs 80 because you would have already sold it. This is one of the drawbacks of a Covered Call.

Risks of Covered Call strategy

Although the strategy provides limited insurance from an unwanted short-term price rise, it can lead to one compromising on a huge profit for a paltry one. Here, had you not written the Call Option, you could have made Rs 30 per share when the stock appreciated to Rs 80 in twelve months (as expected). However, now, you have to settle for a profit of just Rs 4 per share by forcibly selling it at Rs 54 in lieu of the exercise of the Call Option.