Options such as puts and calls are considered derivative contracts since their worth hinges upon an underlying asset. These contracts allow you to speculate or hedge against price fluctuations in the underlying asset. A covered call is particularly noteworthy among the various types of options due to its simplicity and relatively low risk.

Covered Call Option Meaning

A covered call strategy involves selling a call option on a stock that the option writer already owns. Typically, a call option is written for 100 shares of the underlying stock. In a covered call, the writer can sell an option on the stock they already own, referred to as an overwrite, or they can simultaneously buy the stock and sell the call in a buy-write transaction.

When investors write a covered call, they exchange some of the stock's potential upside for immediate income derived from the premium. However, the risk involved is lower than selling a call without owning the stock, known as a naked call.

Selling a naked call exposes the investor to unlimited potential losses as they would be required to obtain the stock at the market price to fulfill the contract. For instance, if a naked call with a strike price of Rs 10 is sold, the investor would lose the difference between the market price and the strike price. As the market price surges higher, the investor would have to pay more for the stock they are obligated to sell at Rs 10.

Owning the underlying stock limits the potential loss for the investor. Nevertheless, they have also sacrificed the opportunity for future price appreciation in exchange for the income earned from the option premium.

Example of a Covered Call Strategy

Let's examine an example to understand how a covered call operates. Suppose, shares of XYZ Company trade at Rs. 10 each. A call option with a strike price of Rs. 10 and a six-month expiration is being sold for Rs. 1. Remember, the option contract represents 100 shares.

To execute a covered call, you can purchase 100 shares of XYZ Company for Rs. 1,000. By selling a call option, you will generate a premium of Rs. 100, equivalent to Rs. 1 per share.

Even if the stock price drops by the premium amount of Rs. 1, you will break even at Rs. 9 per share. If the stock price falls below Rs. 9 per share, you will experience a loss. In such a scenario, money will be expired by the call option, and you will retain both your stock and the premium.

With a market price of Rs. 10 per share, it is unlikely that the purchase will be exercised. Consequently, you will have earned a profit equal to the premium amount.

However, if the market price surpasses Rs. 10 per share, the buyer will exercise the option, obligating you to sell your stock. Your maximum gain will be Rs. 100, equivalent to the premium amount, and you will have forfeited any additional appreciation beyond the strike price.

Advantages of a Covered Call Strategy

1. Covered calls generate income from holdings that would not otherwise provide a cash flow stream, making them popular for selling
2. Investors periodically sell covered call options to add to a position's return
3. A covered call acts as a hedge and offers some protection for a position, reducing the breakeven price due to the premium
4. Selling covered calls is an easy and low-risk strategy because the stock position "covers" the short call

Covered Call Strategy Disadvantages

1. Selling a covered call sacrifices a stock's upside potential
2. A significant rise in the stock price could result in a big sacrifice for the small gain from the premium
3. The option premium's potential gain is low when compared to the downside risk of owning the stock
4. Setting up a covered call is more expensive than other types of strategies with options because you must buy the stock.
5. If the option is exercised and you sell the stock, there may be tax liabilities, especially when reporting a capital gain

The Right Time to Sell a Covered Call

Selling a covered call is most beneficial when you expect minimal movement in the stock price. If the price remains relatively stable, you can collect the premium while retaining the stock for potential appreciation even after the option expires.

The option premiums can generate income similar to dividends. Limiting your covered call strategy to tax-advantaged accounts is also advisable, as both the premium income and the stock being called can lead to tax obligations.

It would be unwise to sell a call and forfeit potential gains if you have a reason to anticipate a rise in the stock price, whether due to a bull market or stock-specific news. Instead, wait until you believe the price has reached its peak before considering writing a covered call.

If you anticipate a drop in the stock price, it is wiser to sell while you can instead of relying on the relatively small option premium to hedge your position.