What is a covered call strategy and when is it used?

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.