How to Trade a Covered Call?

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How to Trade a Covered Call?

Trading a covered call is a popular strategy among equity and derivative traders looking to generate additional income from their existing stock holdings. This article walks you through the mechanics, benefits, risks, and a step-by-step guide to executing a covered call, with examples in INR to make the concept relatable for Indian investors.

What is a Covered Call?

A covered call is an options trading strategy where an investor holds a long position in a stock and simultaneously writes (sells) a call option on the same stock. The primary goal is to earn premium income from the sold option, offering a partial hedge against downside risks.

Benefits of a Covered Call

  1. Income Generation: You receive a premium upfront for writing the call option.
  2. Risk Reduction: The premium received provides a cushion against minor declines in the stock price.
  3. Enhanced Returns: If the stock remains below the strike price, you keep the premium and the stock.

Risks of a Covered Call

  1. Limited Upside: If the stock’s price rises significantly above the strike price, your potential profit is capped.
  2. Stock Depreciation: If the stock price falls significantly, the premium may not fully offset your loss.
  3. Assignment Risk: If the stock’s price exceeds the strike price, the buyer of the call may exercise their option, and you must sell the stock at the strike price.

Step-by-Step Guide to Trading a Covered Call

1. Own the Stock

The first prerequisite for a covered call is owning the underlying stock. For example, suppose you own 500 shares of Tata Consultancy Services (TCS), currently trading at INR 3,500 per share.

2. Choose a Call Option to Sell

Decide on the call option you want to sell. This involves selecting:

  • Strike Price: Typically, traders choose a strike price slightly above the current market price.
  • Expiry Date: Options can have weekly, monthly, or longer-term expiries.

For instance, you could sell a TCS call option with:

  • Strike Price: INR 3,700
  • Expiry: Monthly
  • Premium: INR 50 per share (INR 50 × 500 shares = INR 25,000 total premium received).

3. Execute the Trade

  • Log into your trading account.
  • Go to the options chain for TCS.
  • Select the call option (INR 3,700 strike).
  • Sell (write) the option and collect the premium.

4. Manage the Position

Once the trade is live, monitor the stock and option price until the expiry date. Here are the possible scenarios:

  • Stock Price Below Strike Price (INR 3,700):
    • The call option expires worthless.
    • You keep the premium (INR 25,000) as profit and retain your TCS shares.
  • Stock Price Equals Strike Price (INR 3,700):
    • The call option may be exercised.
    • You sell your shares at INR 3,700, gaining capital appreciation (INR 200 per share) in addition to the premium.
  • Stock Price Above Strike Price (e.g., INR 3,800):
    • The call option will likely be exercised.
    • You sell your shares at INR 3,700 (strike price), missing out on additional gains above INR 3,700.
    • Your effective sale price is INR 3,750 (strike price + premium).

5. Rollover or Adjust

If the stock price approaches the strike price and you do not wish to sell your shares, consider:

  • Rolling Over: Buy back the current call option and sell a new one with a higher strike price or later expiry.
  • Closing the Position: Buy back the call option to nullify the obligation.

Key Considerations

  1. Stock Selection: Choose fundamentally strong stocks you are comfortable holding.
  2. Strike Price Selection: Balance between risk and reward by selecting an appropriate strike price.
  3. Market Conditions: Understand the overall market sentiment to align your strategy.
  4. Brokerage and Taxes: Factor in trading costs and short-term capital gains tax (STCG) implications.

Example: Real-Life Scenario

  • Stock: Reliance Industries (RIL)
  • Shares Owned: 300
  • Current Price: INR 2,500 per share
  • Call Option Sold: INR 2,600 strike price with a premium of INR 30 per share
  • Premium Earned: INR 30 × 300 = INR 9,000

Outcomes:

  1. Stock Price at Expiry = INR 2,580:
    • The call option expires worthless.
    • You keep the premium and the shares.
  2. Stock Price at Expiry = INR 2,600:
    • The option is exercised.
    • You sell the shares at INR 2,600, gaining INR 100 per share in addition to the premium.
  3. Stock Price at Expiry = INR 2,700:
    • The option is exercised.
    • You sell at INR 2,600 but effectively earn INR 2,630 (strike price + premium).

Conclusion

The covered call strategy is an excellent tool for generating consistent income, particularly in a sideways or slightly bullish market. However, understanding its risks and benefits is crucial for successful implementation. By carefully selecting the stock, strike price, and monitoring market conditions, Indian investors can use this strategy to enhance their portfolio returns while maintaining control over their assets.

Disclaimer

The information provided on this blog is for educational purposes only. The views expressed here are based on personal research and opinions and are not intended to be professional financial, legal, or investment advice. Always consult with a qualified professional or financial advisor before making any significant decisions related to investments, finance, or legal matters.

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