In this article, we’re going to explore one of the simplest but quite effective option strategies i.e covered call. If you are a beginner, then you should start your option trading journey using covered call. It is a simple, and effective way to earn extra monthly income (anywhere between 1%-3% per month). Before we proceed further, we hope that you have gone through our first article. If not, we recommend going through that article available at this URL: https://www.coinstreet.in/option-trading-how-to-trade-in-options/

Covered Call

Imagine you own a valuable house that you want to keep for a long time, but you have to move to a different city for work or other reasons. In this situation, your house would be empty while you live in another city in a different house. What would you do? Well, you could rent out your property while you’re away and earn rental income from it.

Now, let’s apply a similar idea to stocks. Imagine you own shares of a company like TCS (Tata Consultancy Services), and you think the stock has reached its full value, meaning it’s unlikely to go up significantly in the near future. However, you still believe in its long-term potential and want to hold onto it. So, what can you do to make some money while the stock moves sideways?

That’s where the covered call option strategy comes in. It’s like renting out your house, but with stocks. Here’s how it works:

• You own the stock: Just like you own your house, you own shares of TCS because you believe it has good long-term potential.
• Sell call options: With the covered call strategy, you sell call options on the TCS stock you own. A call option gives the buyer the right (but not the obligation) to buy the stock from you at a specific price within a certain timeframe. By selling these call options, you earn a premium (income) from the buyer.
• Earn income: When you sell the call options, you receive a payment (premium) regardless of whether the stock price goes up or stays the same. This income helps you make money while the stock remains relatively stable.
• Possible obligation to sell: By selling the call options, you have a commitment to sell your stock if the buyer decides to exercise their right to buy it at the predetermined price before or on the expiration date. So, if the stock price rises above that price, you might have to sell your stock at a fixed price, which limits your potential profits.

The covered call strategy allows you to generate income from your stock while still holding onto it for the long term. It’s a way to make some money when you think the stock won’t have significant price increases.

It’s time now to define the strategy formally.

Covered Call Definition: A covered call is an options strategy that allows an investor to generate income from a stock they already own. To create a covered call, the investor sells a call option (usually ATM call or slightly OTM call options) on the stock they own. You must choose the strike price such that probability of this call option expiring in the money is low.

Why use a covered call?

Covered calls can be a good way to generate income from stocks you already own. They can also be used to limit your downside risk if you are concerned that the stock price might fall. Additionally, covered calls can be a way to increase your return on investment if you believe that the stock price will rise, but not by a lot.

How does a covered call work?

When an investor sells a covered call, they receive a premium from the buyer of the option. This premium is income for the investor. If the stock price stays below the strike price at expiration, the option will expire worthless, and the investor will keep the stock and the premium. However, if the stock price rises above the strike price at expiration, the buyer of the option will exercise their right to buy the stock from the investor at the strike price. The investor will then sell the stock to the buyer for the strike price, and they will keep the premium they received when they sold the option. Let’s understand this through an example

The below diagram shows the option chain for TCS. You can access the option chain data for all stocks and index option from the NSE website (nsesindia.com/option-chain).

In this example, TCS is currently trading at INR 3,306. To initiate the covered call,

• Buy TCS stock in cash market and take delivery
• Sell an OTM Call Option, say 3400 strike CE

Covered Call Payoff Diagram

The payoff diagram for the TCS covered call strategy is as follows:

As we have sold a call option, our upside potential is capped, (which is Profit from Stock holding – Loss from Sold calls + Premium received). There are 3 scenarios possible now:

• TCS closes below 3400
• TCS closes at 3400
• TCS closes above 3400

In the first 2 scenarios, the sold call option will expire worthless, and you will retain the entire premium received from selling the OTM call option. This is our ideal scenario and objective of using the strategy.

In the third scenario, if TCS crosses 3400, you need to evaluate the stock again. If you feel stock has more upside, you are better off exiting your short call and hold the underlying. If you feel this momentum (spurt in stock price) is temporary, in that case you can roll your position. This is done as follows:

• Step 1: Exit the near month call. In our example, we will exit the Jun’23 expiry position. If you don’t exit this position then on expiry, you will have to give delivery against the sold call. Remember that stock option in India is settled through physical settlement. So, if you have sold a call option on TCS and that option is exercised on expiry then you need to give the delivery of TCS shares. Your broker will debit it from your demat account. If you don’t have it in your demat account, you may end up paying a hefty penalty.
• Step 2: Write a fresh OTM or ATM call for next month’s expiry i.e Jul’23. If the spurt in stock price is temporary, you should ideally write ATM or even ITM (In the Money call) to get extra premium.

Let’s see how much we can earn monthly by doing this. INR 22 premium at current stock price translates into ~ 0.7% monthly (22/3306). This is assuming that the underlying stock is purchased at 3306 i.e at current market price. Now you may feel that this 0.7% return is quite low for the risk you are taking. But note that on an annualized basis this is ~ 10% which is a blessing in a bear and sideways market. Remember TCS is down ~25% from its Oct’21 high. In such a scenario, covered call offers you additional income. This is why we have mentioned that it’s a good strategy to apply on your existing stock portfolio and not as a trading strategy.

Covered Call – Additional pointers for improving success probability

Here are few pointers which will help you in increasing your odds of succeeding in covered call strategy:

Stock Selection: Select only large blue-chip names which are less volatile. A few examples are names like TCS, Reliance, HDFC Bank, HUL, ITC etc.

Stock Outlook: Stock should not be trending up or down. It should be in sideways consolidation with positive bias (slightly bullish). Ideally, you should use covered call on your existing stock portfolios just like owning a house to earn rent from it

Using Charts: You can use technical charts to identify areas of a strong supply zone and choose that strike price for writing calls. Wait for stocks to reach near overbought zones and then write calls. You can use indicators like RSI (relative strength index) to identify overbought and oversold zones

Volatility Impact: Keep an eye on the volatility. If implied volatility is high this would mean higher option premium. However, this could also lead to erratic price movement.

Conclusion

Covered calls can be a good way to generate income from stocks you already own. One of the major issues with the covered call is that it requires a very high margin. To buy one lot of TCS at the current market price will require ~INT 5.75 lakhs. You would need an additional margin for selling the call option (anywhere between INR 1-2 lakhs). Hence, it is preferred only to do occasionally to boost portfolio returns.

It will require some practice but with experience this strategy adds a lot of value to a portfolio investor. A stock remains in consolidation for a long time and your money is not earning you anything. Since you wish to hold the stock anyways, you have evaluated your downside case and you can earn from writing covered call. With experience, you can earn extra amount by writing ATM call which offers you higher return ~ 2% monthly.

If you have any queries or suggestions, don’t forget to mention that in the comment box