Learn how to set up a covered call position

This week, we discuss covered call strategy. The objective of this strategy is to collect call premium without assuming the risk associated with a short option position.

Income strategy

Covered call is a strategy that is long on an underlying and short on an out-of-the-money (OTM) call on the same underlying. That is, you buy an underlying and simultaneously short (write) a call option on the underlying. It is, therefore, also called buy-write strategy.

Suppose an underlying currently trades at 2005. You believe that it is unlikely to move above 2070 (resistance level) before the near-month option contract expires. You can then short the strike which is immediately above this resistance level (say, 2100).

You should buy shares in multiples of the lot size of the options contract. That is, if an option contract on the underlying has a lot size of 250, then you should buy 250 shares of the underlying. This helps in two ways. One, if the underlying trades above 2100 at option expiry, you will be required to deliver the shares. Having the required number of shares in your demat account will allow you to meet your obligation on the short call. Two, your margin will be lower when the short call position is covered by the underlying.

Suppose the stock trades at 2500 at option expiry. The 2100 call will carry 400 points of intrinsic value. That means you have a loss of 400 points less the premium collected on your short position. But your stock would have also gained in value. Therefore, the loss on the short call will be offset by the gain from the long stock.

The maximum profit on this position is the call strike less the purchase price of the stock plus the call premium. In the above example, that would be 135 points times the lot size (2100 less 2005 plus call premium of 40 points). Your maximum risk is the purchase price less call premium (1965). This is also the break-even for the position.

Given the downside risk on the underlying, it is important that you identify stocks that indicate clear uptrend or sideways movement. Importantly, avoid stocks that are volatile or have noisy chart pattern. Also, your short calls should be on near-month equity options and, perhaps, on weekly index options.

Note that the principle behind a covered call is similar to the one you would follow for a bull call spread. This strategy uses a long stock instead of a long position on a lower strike call in a bull call spread. In both cases, you should preferably short a call that is one strike above the resistance level. For this reason, it is moot if a covered call is truly an income strategy. After all, you are also capturing some upside in the underlying.

Optional reading

You could also set up a covered call when holding a stock that you do not intend to sell immediately. This could be your employer stock that was vested to you through a stock option programme. Or it could be a stock that has been in your portfolio for a long time. You could short an OTM call if you believe that the stock is likely to face a strong resistance close to its current price.

In fact, a covered call can be appropriately called as an income strategy when you short an OTM call against a stock that you already hold in your demat account. The objective in this case is simply to collect the call premium without assuming the risk of a naked short position on the call. The worst-case scenario is that your stock will be called away if the short call expires in-the-money. But you are likely to get an opportunity to buyback the stock at a later date at a lower price.

The writer offers training programmes for individuals to manage their personal investments

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