The covered call strategy is an options trading strategy that involves selling call options on a stock that you already own. This strategy can be used to generate income from your stock holdings while potentially limiting your downside risk. Here’s how you can implement the covered call strategy, along with an example:
- Select a Stock: Choose a stock that you already own or are willing to purchase. Look for stocks with a stable or moderately bullish outlook.
- Determine the Strike Price and Expiration Date: Identify the strike price and expiration date for the call options you will sell. The strike price is the price at which the buyer of the call option can purchase the stock from you. The expiration date is the date on which the options contract expires.
- Assess Premium and Potential Returns: Evaluate the premium (price) of the call options at your chosen strike price and expiration date. This premium represents the income you will receive from selling the options. Consider the premium in relation to your desired rate of return and risk tolerance.
- Sell Call Options: Sell call options on the stock you own, with a strike price and expiration date determined in Step 2. For each 100 shares of stock you own, sell one call option. This is known as writing a covered call.
- Wait for Expiration or Buy Back: Monitor the price movement of the underlying stock until the expiration date. There are three possible outcomes:
- If the stock price remains below the strike price, the options will expire worthless, and you keep the premium as profit.
- If the stock price rises above the strike price, the buyer of the options may exercise them, requiring you to sell your shares at the strike price. In this case, you still keep the premium received, but you miss out on further potential gains from the stock.
- If the stock price is close to the strike price near expiration, you may choose to buy back the call options to avoid being assigned. This allows you to keep your shares and potentially write new call options in the future.
Example:
Let’s say you own 200 shares of XYZ stock, currently trading at ₹50 per share. You decide to implement the covered call strategy as follows:
- Stock Selection: XYZ stock has been performing well, and you believe it will continue to be stable in the short term.
- Strike Price and Expiration Date: You choose a strike price of ₹55 and an expiration date in three months.
- Premium and Potential Returns: After analyzing the options market, you find that call options with a ₹55 strike price and three-month expiration are trading at a premium of ₹2 per option. As you own 200 shares, you can sell two call options, receiving a total premium of ₹400 (₹2 x 200).
- Sell Call Options: You sell two call options on XYZ stock with a strike price of ₹55 and three-month expiration, receiving a premium of ₹400.
- Expiration or Buy Back: Over the next three months, the stock price remains below ₹55, and the call options expire worthless. You keep the ₹400 premium as profit. If the stock had risen above ₹55, you would have had to sell your shares at ₹55 per share, but you would still keep the ₹400 premium.
Remember, options trading involves risks, and it’s crucial to understand the potential outcomes and manage your positions accordingly. It’s advisable to consult with a financial advisor or conduct thorough research before implementing any trading strategies.
