In a covered call, the trader buys a position in cash and then sells a higher call option. The premium received on the call option is used to reduce the cost of the cash market position. Let us how the payoff of such a position will work with a practical example.
Bought SBI at Rs.280 and sold Rs.300 call at Rs.5
Option Strike
Stock Buy Price
Market Price
P/L Spot
Option ITM/OTM
Option Premium
P/L on Call
Net Profit / loss
300
280
220
-60
OTM
5
0
-55
300
280
225
-55
OTM
5
0
-50
300
280
230
-50
OTM
5
0
-45
300
280
235
-45
OTM
5
0
-40
300
280
240
-40
OTM
5
0
-35
300
280
245
-35
OTM
5
0
-30
300
280
250
-30
OTM
5
0
-25
300
280
255
-25
OTM
5
0
-20
300
280
260
-20
OTM
5
0
-15
300
280
265
-15
OTM
5
0
-10
300
280
270
-10
OTM
5
0
-5
300
280
275
-5
OTM
5
0
0
300
280
280
0
OTM
5
0
5
300
280
285
5
OTM
5
0
10
300
280
290
10
OTM
5
0
15
300
280
295
15
OTM
5
0
20
300
280
300
20
ATM
5
0
25
300
280
305
25
ITM
5
-5
25
300
280
310
30
ITM
5
-10
25
300
280
315
35
ITM
5
-15
25
300
280
320
40
ITM
5
-20
25
300
280
325
45
ITM
5
-25
25
300
280
330
50
ITM
5
-30
25
300
280
335
55
ITM
5
-35
25
300
280
340
60
ITM
5
-40
25
When is a covered call used? Typically, when you bought a stock and the stock goes down, you can sell higher calls to ensure that you take the premium each month and reduce your cost of holding. If it goes up higher, then you have your cash market position so the call writing is not a worry. However, this covered call position is open on the downside and the risk can be quite high. This strategy should only be used when you believe that the bottom of the market is close by and the stock is unlikely to bounce very sharply.
Let us understand the table above. The breakeven point is Rs.275 after the premium of Rs.5 on the call sold is covered. Below that, your losses are progressively getting worse. On the upside, the maximum profit of Rs.25 is earned at the level of Rs.300, where you have sold the call option. Beyond this point, whatever you gain on the cash market position you lose on the call written by you. From that point you are neutral overall on the stock position. That is why this is called a moderately bullish strategy as your maximum profit is at Rs.300. Here your maximum profit of Rs.25 consists of the Rs.20 price difference (300 - 280) and the premium of Rs.5 received for writing the call option. This strategy should be used ideally when you are moderately bullish on stock.
In a covered call, the trader buys a position in cash and then sells a higher call option. The premium received on the call option is used to reduce the cost of the cash market position. Let us how the payoff of such a position will work with a practical example.
Bought SBI at Rs.280 and sold Rs.300 call at Rs.5
Option Strike
Stock Buy Price
Market Price
P/L Spot
Option ITM/OTM
Option Premium
P/L on Call
Net Profit / loss
300
280
220
-60
OTM
5
0
-55
300
280
225
-55
OTM
5
0
-50
300
280
230
-50
OTM
5
0
-45
300
280
235
-45
OTM
5
0
-40
300
280
240
-40
OTM
5
0
-35
300
280
245
-35
OTM
5
0
-30
300
280
250
-30
OTM
5
0
-25
300
280
255
-25
OTM
5
0
-20
300
280
260
-20
OTM
5
0
-15
300
280
265
-15
OTM
5
0
-10
300
280
270
-10
OTM
5
0
-5
300
280
275
-5
OTM
5
0
0
300
280
280
0
OTM
5
0
5
300
280
285
5
OTM
5
0
10
300
280
290
10
OTM
5
0
15
300
280
295
15
OTM
5
0
20
300
280
300
20
ATM
5
0
25
300
280
305
25
ITM
5
-5
25
300
280
310
30
ITM
5
-10
25
300
280
315
35
ITM
5
-15
25
300
280
320
40
ITM
5
-20
25
300
280
325
45
ITM
5
-25
25
300
280
330
50
ITM
5
-30
25
300
280
335
55
ITM
5
-35
25
300
280
340
60
ITM
5
-40
25
When is a covered call used? Typically, when you bought a stock and the stock goes down, you can sell higher calls to ensure that you take the premium each month and reduce your cost of holding. If it goes up higher, then you have your cash market position so the call writing is not a worry. However, this covered call position is open on the downside and the risk can be quite high. This strategy should only be used when you believe that the bottom of the market is close by and the stock is unlikely to bounce very sharply.