The Covered Call is a popular and relatively low-risk options strategy that allows investors to generate extra income from the stocks they already own. By selling call options on a stock that you hold, you collect a premium and get paid for agreeing to sell the stock if it reaches a certain price (the strike price).
How It Works:
- Own the Stock: You first need to own at least 100 shares of the stock.
- Sell a Call Option: You sell a call option on the stock, giving the buyer the right to purchase your shares at a strike price by a specific expiration date.
For example, if you own 100 shares of ABC stock currently trading at ₹100, you can sell a ₹110 strike price call and collect a premium. If the stock stays below ₹110, the option expires worthless, and you keep the premium. If the stock price exceeds ₹110, you’ll be obligated to sell your shares at ₹110, but you still keep the premium.
Profit Potential:
- Maximum Profit: The maximum profit occurs if the stock stays below the strike price by the option’s expiration. You keep the premium collected and continue to hold the stock.
- Example: If you sold a call option for ₹5 and the stock price remains below the strike price, you keep the ₹5 premium as profit.
- If the Stock Price Rises Above the Strike Price: You’ll be required to sell your shares at the strike price, which could be lower than the market price. However, you still profit from the premium collected plus the stock appreciation up to the strike price.
- Example: If you sell a ₹110 strike call and the stock rises to ₹120, you’ll sell the shares at ₹110, missing out on the ₹10 gain beyond the strike price, but you still keep the premium.
Risk:
The Covered Call strategy is considered low-risk because you already own the stock. However, the main risk is that you might have to sell your stock at the strike price if the stock price rises sharply. This means you might miss out on further gains beyond the strike price.
When to Use a Covered Call:
- Stable or Slightly Bullish Market: The Covered Call is best used when you believe the stock will remain stable or rise slightly. It helps you generate extra income without selling the stock.
- Neutral Outlook: If you don’t expect big price movements, this strategy can help you profit from a sideways market by collecting the call premium.
Advantages:
- Extra Income: You collect premiums from selling call options, providing steady income in addition to any dividends or stock appreciation.
- Low Risk: Since you already own the stock, your risk is limited to losing potential upside if the stock price rises above the strike price.
- Hedge Against Market Drops: The premium collected can help offset small losses in the stock if the market drops slightly.
Disadvantages:
- Limited Upside: If the stock price rises sharply, you’ll have to sell your shares at the strike price, missing out on further gains.
- Still Subject to Stock Price Drop: If the stock price falls sharply, the premium collected may not fully cover your losses.
Example of a Covered Call:
- Stock Owned: 100 shares of ABC stock trading at ₹100.
- Sell a Call Option: Sell a ₹110 strike price call for a premium of ₹5.
Possible Scenarios:
- Stock Stays Below ₹110: You keep the ₹5 premium, and the call option expires worthless. You still own the stock.
- Stock Rises Above ₹110: You’ll have to sell your stock at ₹110, but you still keep the ₹5 premium and make a profit from stock appreciation up to ₹110.
Conclusion:
The Covered Call strategy is a great way for investors to generate extra income from stocks they already own, especially in stable or slightly bullish markets. By selling call options, you can profit from premium collection while keeping your stock ownership intact. It’s a conservative strategy with limited risk and is ideal for long-term investors looking to enhance their returns.