Covered Call
- What is a Covered Call and when should you use it?
- Understanding the risks of trading in Covered Calls
- Covered Calls vs. Covered Puts
- Key considerations while trading Covered Calls and Covered Puts
A Covered Call is a popular options strategy used by investors who already hold stocks in their portfolio. Instead of liquidating their holdings during flat or mildly bearish markets, they utilise the Covered Call approach to generate additional income from options without selling their equity holdings.
Interestingly, even traders without any existing stock portfolio can employ this strategy when they have a moderately bullish outlook on the market.
What is a Covered Call?
The Covered Call strategy comprises two essential components:
Holding the stock or portfolio
Writing (selling) Call Options
These Call Options may be based on the stocks held or even on an index. This strategy limits the upside potential because once the stock rises beyond a certain point, the sold call option begins to incur losses, capping the overall gains.
Payoff Diagram
The following chart illustrates the Covered Call position using HDFC Bank as an example:
A Covered Call strategy was created by:
Buying 1 lot of HDFC Bank Futures (25th August 2022 expiry)
Selling 1500 Call Options (25th August 2022 expiry)
Note: The expiry date for both the futures and options must match.
As the payoff diagram indicates, the profit curve flattens beyond a specific price level.
Maximum Profit = (Strike Price – Buying Price) + Premium Received
Breakeven = Stock Purchase Price – Premium Received
Maximum Loss = Unlimited (if the stock price falls sharply)
Why Traders Use Covered Calls
Covered Calls are often preferred over simply holding shares because the premium from selling the Call Option helps offset any sideways or downward movement in the stock. For long-term investors, this strategy also helps lower the effective acquisition cost of the stock.
How to Select the Right Strike Price
Strike selection depends on the trader’s risk tolerance and return expectations:
Conservative traders often sell options with a 10-delta, which have lower premiums and higher probability of expiring worthless.
Less conservative traders may opt for 30-delta strikes, aiming for higher premiums.
Some traders use a fixed ROI model. For instance, aiming for a 2% monthly return, they sell Calls with premiums equivalent to 2% of the stock price.
Example: If HDFC Bank trades at ₹1,471.7, the trader might look for Call Options priced around ₹29 to align with this goal. If the stock stays flat or declines, the trader earns the full premium.
Which Expiry to Choose?
Stock Options: Most traders prefer current-month expiries due to higher liquidity.
Index Options: Expiries 30–45 days out are more common to balance time decay and ROI.
Longer expiry periods offer flexibility and improve trade success probability.
When to Exit a Covered Call Position?
Exit when the stock price crosses the strike price—the profit potential has been maxed out.
Square off the short Call when it has lost most of its value due to time decay or a decline in the stock price.
Risks in Covered Call Strategy
If the underlying stock drops sharply, the loss from the stock could exceed the premium collected from the Call Option. In such situations, traders may:
Book profits on the short Call
Shift the strike lower
Roll the position to the next expiry
This helps mitigate risk while continuing to collect premiums.
Conclusion
A Covered Call strategy is ideal for investors who want to enhance returns or reduce holding costs on their equity portfolio. By selling Out-of-the-Money (OTM) Calls, one can generate consistent income while maintaining a neutral to bullish outlook.
This strategy is widely used by institutional investors and experienced traders, especially during range-bound market phases.
Covered Puts
While Covered Calls suit bullish sentiments, Covered Puts are used when traders expect a neutral to bearish market.
What is a Covered Put?
This strategy combines:
Shorting the stock or index
Selling a Put Option
It is designed to profit when the stock declines moderately or stays range-bound.
Payoff Diagram
Example: A Covered Put on HDFC Bank
Short Futures: HDFC Bank trading at ₹1,468.7 (25th August 2022 expiry)
Sell OTM Put: Strike Price ₹1,440 at ₹2.8 premium
Breakeven = Short Sell Price + Premium Collected
Maximum Profit = (Short Sell Price – Put Strike) + Premium Received
When to Enter a Covered Put
This strategy is suitable when the trader expects the stock to stay flat or decline slightly from current levels.
Risks of a Covered Put Strategy
If the trade goes against the view and the stock rallies significantly, the loss is theoretically unlimited. To limit damage, traders may:
Exit the sold Put
Shift the strike higher
Roll the position to a future expiry to collect additional premium
Conclusion
A Covered Put is conceptually similar to the Covered Call but is applied in bearish to neutral market conditions. While less popular since shorting is generally riskier and less favored it can be effective for traders confident in a downward bias.
Things to Remember
A Covered Call is suitable for investors with a stock portfolio expecting the market to stay flat or move up slightly.
Even traders without a portfolio can initiate a Covered Call if they are moderately bullish.
Covered Puts are the bearish counterpart of Covered Calls, used when the outlook is neutral to bearish.
Both strategies involve capped profits but expose the trader to unlimited losses in adverse movements