A covered call is a strategy where you short a higher strike call against an underlying. Previously in this column, we discussed when a covered call can be compared to a bull call spread. This week, we show how to implement covered call as a pure income strategy.

Income returns

If you intend to earn income by writing (shorting) calls, you should identify stocks that you prefer to keep as part of your core investments. These could be legacy (inherited wealth) stocks on which you receive cash dividends and stock dividends (bonus shares). These could also be stocks that you continually accumulate when price is attractive. Or shares that you received as part of your employee stock options and intend to hold till you leave your current employment.

Importantly, these are stocks that are not part of your trading portfolio. For if you apply covered call strategy on your trading portfolio, then it would be more like a bull call spread than like an income strategy.

Also, the stock should be entering a consolidation phase — a phase where the stock creates lower highs (and preferably higher lows) after a noticeable uptrend. A stock is said to be an uptrend when it creates higher highs and higher lows. So long as the stock does not break below a crucial support level during the consolidation phase, the uptrend is intact.

Such a situation is optimal to set up a covered call strategy for two reasons. One, you are willing to hold the stock for a while. And two, the stock has a low probability of being called away against the short call. Note that you will not suffer losses if the short call becomes ITM. The long stock position will neutralise the losses on your short call if the stock trades above the strike price at expiry. You would, however, have to give up your stock as you may be required to deliver the shares against your short call position.

The income returns from your covered call should be calculated as a percentage of the gains on the invested amount. For instance, if you have invested ₹2.5 lakh in a stock and gains from the short call are ₹25,000, then your return is 10 per cent. Note that the number of shares you hold should be in multiples of the permitted lot size. This is important because you want the shares you hold to cover the short call position.

Optional reading

To reduce the risk of the stock being called away, you should consider writing deep out-of-the-money (OTM) calls. The flip side is that you may not gain much because the premium on these calls will be low. You can also consider shorting near at-the-money calls during the week before expiry. This is because time decay accelerates when the option approaches expiry, as time value of all options must be zero at expiry. Importantly, shorting the call close to expiry reduces the risk of the stock being called away, as it has limited time to break out on a momentum.

Note that the maximum gain on a covered call strategy is determined as the difference between the call strike and the cost of the stock plus the call premium. Some analysts prefer to calculate maximum gains based on the stock price at the time the call is written, not the purchase price of the stock. The argument is based on opportunity cost.

Including gains from the stock in the calculation is meaningful when your view is that the stock is likely to move up and face resistance at a higher level. That is when the strategy can be meaningfully compared to a bull call spread. But if your objective is to keep your stock and earn income returns, then why would you consider gains on the stock as part of the calculation?

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

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