You own shares in a company that you believe may rise only modestly or stay sideways in the near term, and you still want to earn income from the shares. The Covered Call strategy is employed when an investor sells a Call option on a stock they own, netting them a premium. The Call Option is usually an Out Of The Money (OTM) Call, meaning the Call Option's strike price is higher than the prevailing market price of the underlying stock. The Call would only get exercised if the stock price increases above the strike price. Until then, the Call seller can retain the premium as income from the stock. This strategy is typically adopted when the investor is neutral to moderately bullish about the stock.
Scenario 1: Neutral to Moderately Bullish View
Investor's Action: The investor sells an OTM Call option on a stock they own.
Outcome: If the stock price remains at or below the strike price, the Call option will not be exercised, and the investor retains the premium as additional income. If the stock price goes above the strike price, the Call option will be exercised, and the investor sells the stock at the strike price, earning both the target exit price and the premium.
When to Use: This strategy is often employed when an investor has a short-term neutral to moderately bullish view on the stock they hold. It is used to generate income from the option premium while having a target exit price for the stock.
Risk: The maximum risk occurs if the stock price falls to zero. In this case, the investor loses the entire value of the stock but retains the premium, as the Call option will not be exercised against them. The maximum risk is calculated as Stock price paid – Call premium. The upside is capped at the strike price plus the premium received.
Reward: Limited to (Call strike price – Stock price paid) + premium received
Breakeven: Stock price paid - Premium received
Example:
Mr. A buys XYZ Ltd. for ₹3850 and simultaneously sells a Call option at a strike price of ₹4000.
Mr. A receives a premium of ₹80 for selling the Call.
Net outflow to Mr. A is (₹3850 – ₹80) = ₹3770.
If the stock price stays at or below ₹4000, the Call option will not get exercised, and Mr. A retains the ₹80 premium as extra income.
If the stock price goes above ₹4000, the Call option will be exercised, and Mr. A sells the stock at ₹4000, earning both the target sell price and the premium.