Finance

Covered Call Option Strategy

Covered Call Option Strategy

Covered Call implies selling a call option on a stock that is owned by the option writer. It is an option strategy involving the trading of both the underlying stock and the options contract. The number of call options and the stock holding must be the same, and the stock must be held until the time the option expires or is squared off. In addition to receiving a premium for the selling, with covered calls, the investor still has rights to the perks of holding the underlying asset all the way up to the strike price at which the stock will be called off. This is called a covered position.

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Call Option is a derivative contract that gives the holder the right, but not the obligation, to purchase the asset at an agreed price on or before a particular date. Let us understand the Covered Call strategy in the following two scenarios:

  • Out of the money (OTM) option
  • In the money (ITM) option

Out of the money (OTM) option

By writing an out of the money call option, the combined position limits the upside potential at the strike price. In the return for giving up any potential gain beyond the strike price, the writer receives the option premium. This technique is used to gain cash on a stock that is not expected to rise above the exercise price over the time span of the option.

Suppose a firm can sell 10,000 call options on a stock that is currently trading at $20. The strike price of the option is $23, and the option premium $4. With a covered call, if the stock price goes over the $23 strike price, and the option is exercised, the company sells shares already held by it. This minimizes the costs of the short options by locking the revenue from the selling of the option. However, if the stock falls to $10 per share, the long stock position decreases in value by $100,000, which is substantially larger than the premium received from the option sale.

In the money (ITM) option

If the investor writes an initially in the money option, he believes the stock price is going to drop, but investor still want to maintain the stock position, he can sell an in the money (ITM) call option, where the strike price of the underlying asset is lower than the market value.

When selling an ITM call option, you will receive a higher premium from the buyer of the call option, but the stock must fall below the ITM option strike price—otherwise, the buyer of your option will be entitled to receive your shares if the share price is above the option’s strike price at expiration (he then lose your share position).

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Benefits and Risk Involved:

The maximum profit from this strategy is the difference between the strike price and the existing stock plus the premium received for the sale of the call option contract. However, one should be aware of the risks involved in this technique. The possible loss of this strategy could be significant. This occurs when the price of the underlying asset declines. In comparison to stock trading, the downside is negligibly less costly due to the premium received, which will mitigate the downside of stock fluctuations.

Maximum Loss = Stock Entry Price – Option Premium Received

Maximum Profit = (Strike Price – Stock Entry Price) + Option Premium Received

Final Thoughts:

The covered call strategy is a perfect way to produce additional income from holding stocks and are ideal for investors of all proficiency levels. The main goal of the covered call is to collect income via option premiums by selling calls against a stock that you already own. Given that the stock is not above the strike price, you obtain the premium and hold your stock position. When trading covered calls you should take into account the cost of commissions. If they eliminate a large portion of the premium earned, it is not advisable to sell the option or to make a call.

 

Author: Divya Sankhla

About the Author: Divya has completed her graduation in Bachelors of Accounting and Finance. She has worked in Deloitte Touche Tohmatsu Services, Inc. as a Research Analyst for 1 year and at JM financial as a Credit Risk Analyst for 1.3 years. She has a keen interest in learning about Financial Market. Well versed with Bloomberg, Capital Line, and Excel.

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