Understanding the Covered Call Strategy in Trading
Investors often take long positions in the market by purchasing different assets. However, there is also a risk of downside price movement in the future. Seasoned investors often use call options to offset the potential losses while taking long positions. The covered call strategy is not complex like some other trading techniques. Beginners in the stock market can also use this strategy to minimise potential risks. Read on to learn more about the covered call strategy.
What is a Covered Call?
A covered call is a risk management strategy with the help of a call option . You must know that a call option gives you the right to purchase the underlying asset on a future date. The price to purchase the underlying asset on a future date is predetermined in the contract, often known as the strike price. The call option holder can exercise the contract on the expiration date or ignore it. The strategy involves taking a long position in an asset, say stocks. It also involves selling a call option based on the same underlying asset. Since you are taking a long position and selling a call option in the same asset, it minimises the risk.
Maximum Profit and Maximum Loss
Before implementing this strategy, investors must understand the maximum losses and gains. The maximum profit for a covered call is achieved when the asset’s market price goes beyond the call option’s strike price. You can find the difference between the strike price and the purchasing cost of the asset. When done, add the premium received to the total, thus getting the maximum gains. Here’s the formula to calculate the maximum gains:
Maximum Profit = (Strike price of the call option – purchasing cost of the long position asset) + premium received
The maximum loss can occur when the asset’s market price drops to zero, which is highly unlikely. Even if the price drops a little, you can offset losses with the premium received. However, you might incur a loss when the price of the asset drops significantly. Here’s the formula to calculate the maximum losses for a covered call:
Maximum Loss = Purchase cost of the long position asset – premium received
Advantages and Disadvantages
Now that you understand what is a covered call, let us discuss the pros and cons. The most obvious benefit is that you get to collect the premium. You can only lose money when the call option goes in-the-money. The call option will remain unexercised in other cases, thus leading to premium income. Even though your maximum gains are limited, you will minimize risks with this strategy. You can limit losses on the short call option by holding a long position in the same underlying asset.
While retail investors prefer this strategy, institutional investors also use it. Since institutional investors are open to higher risks, they use covered calls for insurance against potential downsides. Also, the strategy is flexible and can be structured to match your long position in the market.
Even though it is useful, you must be aware of the risks. You must write off the same asset quantity in the call option. Let us say you own 100 stocks of a company. You must write off a call option based on 100 stocks of the same company to implement the covered call effectively. If you do not have a long position in the asset, you might have to purchase it from the market when the option holder exercises the contract. Also, the strategy might minimise the potential gains. For the same rationale, highly bullish investors might not use this.
When to Use and When to Avoid Covered Calls
Now that you understand the covered call meaning, let’s delve into when to use it. You can employ this strategy when the asset’s price is expected to rise or fall by a low margin. This strategy is suitable when fewer prospects of exceptionally high profits or losses exist. However, it’s ineffective for an asset with chances of large price swings. This strategy might result in losses when there is a significant price swing.
Example of a Covered Call
Let us understand the covered call strategy with a realistic example. Let us say you have purchased stocks of a company named ‘ABC.’ You have taken a long position by purchasing 50 stocks of ABC. Let us say you feel that the price of stocks will remain the same in the coming months, with little or no movement. Also, the purchasing cost of ABC stocks is Rs 30 per share.
You must now write off a call option based on 50 stocks of ABC to implement the covered call. Since you suspect the price might fall/rise a couple of rupees in the future, the strike price for the call option is Rs 32. You can choose an expiration date of several months for the call option, say two months. Let us say you got a premium of Rs 250 for writing off the call option (Rs 5 per share).
When the contract expires, shares of ABC in the market are trading below the strike price. In such a case, you get to keep the premium, as the option will not be exercised. The option will be exercised when the market price on the expiration date is above Rs 32. However, you will still have the premium to offset the losses.
In a Nutshell
Covered calls can help investors minimize losses on long positions. You must take a long position and sell a call option having the same underlying asset to implement it. The strategy is perfect for assets with minimal or no price swings. However, it might not provide the desired results when the price swings significantly. Learn more about the covered call strategy now!