Covered Call: Meaning, key features and set-up

Overview

Covered calls are like combining your favorite food with a dash of spice – they add a bit of flavor to your stock portfolio. When you sell a call option, you need to own at least 100 shares of the underlying stock because each option contract represents 100 shares. You can either already own these shares or buy them at the same time you sell the call option, which is a form of option selling.

What is Covered Call?

A covered call is an option strategy where an investor sells a call option on a stock they already own to generate extra income. This technique combines stock ownership with option selling, earning a premium in exchange for potentially selling the stock at a specified price if it rises. Ideal for those mildly bullish on their stock, it adds a “renting out” element to their portfolio while managing risk.

When to use a Covered Call?

Use a covered call strategy if you’re moderately optimistic about a stock and plan to keep it for a while.

This strategy helps generate extra income while you hold the stock and lowers your overall cost. It’s like renting out your house while you’re on vacation—why not make a little money on the side?

How to set up a Covered Call?

To set up a covered call, you sell a call option against the shares you own. Usually, you sell a call with a strike price higher than the current stock price. The closer the strike price is to the stock price, the more money (premium) you’ll get, but there’s a higher chance you’ll have to sell the stock if it goes up too much.

Covered Call Payoff Diagram

Selling a covered call limits how much profit you can make but doesn’t remove the risk of the stock dropping. However, it helps reduce risk by the amount of premium received.

Covered Call Strategy Example:

• Initial Setup: Buy stock at ₹1000 and sell a call option with a ₹1050 strike price for ₹50.
• Adjustment: The cost basis of your stock is now reduced by ₹50. So, the new break-even point is ₹950.

If the stock price falls below ₹950, you start losing money, but the premium helps cushion the fall. The risk is still there until the stock hits ₹0, minus the premium received.

At expiration:

• If stock is Above ₹1050:
  • You make a profit of ₹100 per share from the stock (₹50 from stock rise + ₹50 from premium).
  • Your profit is capped at ₹1000 per contract because you sell the stock at ₹1050.
• If stock is Below ₹1050:
  • The call option expires worthless.
  • You keep the ₹50 premium, and your break-even is still ₹950.

Entering a Covered Call

To enter a covered call, you need to own at least 100 shares of the stock. If you already have the shares, just sell a call option with a higher strike price. If not, you can buy the shares and sell the call option at the same time.

Exiting a Covered Call

You can exit a covered call in two ways:

1. Stock price below strike price at expiration: The call option expires worthless, and you keep the premium. You can then sell another covered call.
2. Stock price above strike price at expiration: Your stock is “called away” at the strike price. You make money up to the strike price plus the premium. If you don’t want to sell the stock, you can roll the call option to a later date.

Time Decay impact on a Covered Call

Time decay works in your favor with covered calls. The closer the expiration date, the less the call option is worth. Covered calls with longer expirations collect more premium, but shorter expirations benefit more quickly from time decay.

Implied Volatility impact on a Covered Call

Higher implied volatility means higher call option prices, as the stock is expected to move more. Selling covered calls when volatility is high brings in more premium, but expect more price swings.

Adjusting a Covered Call

You can change a covered call to manage risk if the stock price moves before the option expires. Here’s how to handle different situations:

1. If stock price rises above strike price:

What happens: If the stock price is higher than the call option strike price when it expires, the option will be exercised. Your broker will sell your shares at the strike price.

• What to do:
  • Do nothing: You sell your shares at the strike price and keep the premium.
  • Roll out: If you want to keep your shares, you can buy back the call option and sell a new one for a later date.

Example:

• Initial: Sold a ₹1000 call for ₹50.
• Stock Rises: Price goes up to ₹1050 at expiration.
• Result:
  • Keep ₹50 premium.
  • Miss out on gains above ₹1000.
  • If you roll out, buy back the ₹1000 call and sell a new one for next month.

2. If stock price stays flat or falls below strike price:

• What happens: If the stock price stays below the call option strike price, the option expires worthless.
• What to do:
  • Open new position: Sell a new call option for a future date at the same or a lower strike price.

Example:

• Initial: Sold a ₹1000 call for ₹50.
• Stock drops: Price stays at ₹950 at expiration.
• Result:
  • Keep ₹50 premium.
  • Sell a new ₹1000 call for the next month.

Rolling a Covered Call

You can roll a covered call up or down before it expires.

1. If stock price drops (Roll Down):

• What to do: Buy back the call option and sell a new one at a lower strike price.
• Benefit: Get more premium but higher chance of the new call being exercised.

Example:

• Initial: Sold a ₹1000 call for ₹50.
• Stock drops: Price drops to ₹950.
• Result:
  • Buy back ₹1000 call for ₹10.
  • Sell new ₹950 call for ₹40.

2. If stock price rises (Roll Up):

• What to do: Buy back the call option and sell a new one at a higher strike price or for a later date.
• Benefit: Keep holding the stock and get more premium.

Example:

• Initial: Sold a ₹1000 call for ₹50.
• Stock rises: Price goes up to ₹1050.
• Result:
  • Buy back ₹1000 call for ₹100.
  • Sell new ₹1050 call for ₹60.

Hedging a Covered Call

You can protect against a price drop by rolling down the call or buying a put option.

Rolling Down:

• What to do: Buy back the call and sell a new one closer to the current stock price.
• Benefit: Get more premium but limit upside.

Example:

• Initial: Sold a ₹1000 call for ₹50.
• Stock drops: Price drops to ₹950.
• Result:
  • Buy back ₹1000 call for ₹10.
  • Sell new ₹950 call for ₹40.

Buying a Put Option:

• What to do: Buy a put option below the strike price of the call.
• Benefit: Protects against further price drops.

Example:

• Initial: Own stock at ₹1000, sold a ₹1050 call for ₹50.
• Adjustment: Buy a ₹900 put for ₹20.
• Result:
  • Right to sell stock at ₹900.
  • Cost of ₹20 reduces total premium to ₹30.

Synthetic Covered Call

A synthetic covered call is a cheaper way to gain long exposure to a stock while selling calls.

Steps:

1. Buy a Long-Term Call (LEAPS): Acts like owning the stock but cheaper.
2. Sell Short-Term Calls: Generate regular premium to offset the cost.

Example:

• Initial: Buy a ₹1000 call (LEAPS) for ₹200.
• Adjustment: Sell monthly ₹1050 calls for ₹20 each.
• Result:
  • Max risk is the cost of the LEAPS (₹200).
  • Each month, reduce risk by ₹20 from the premium of selling calls.

How do Covered Calls differ from other strategies?

Covered calls are a conservative strategy, providing steady income with some risk mitigation, but they aren’t the only approach. Here’s how covered calls compare with other popular strategies:

1. Protective Put: Combines stock ownership with a put option purchase to hedge against downside risk. Unlike covered calls, it costs a premium but offers protection if the stock drops.
2. Collar Strategy: Involves owning stock, selling a call, and buying a put at a lower strike price. It limits both upside and downside, aiming for risk management in volatile markets.
3. Short Call: Selling a call option without owning the underlying stock. It can generate higher premiums but carries unlimited risk if the stock rises, unlike covered calls, where ownership caps potential losses.

Bottom Line

In summary, covered calls offer a balanced approach for generating additional income from your stock investments while mitigating some downside risk. By selling call options on stocks you already own, you can collect premiums that reduce your cost basis and provide a buffer against price declines.

However, it’s crucial to manage and adjust your positions based on stock price movements and market conditions to maximize returns and protect your portfolio.