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.