Option trading Strategy 3:Covered Call

 When to use: 

In this strategy a trader will Buy a stock and sell calls of underlying stock. An options strategy whereby an investor holds a long position in an asset and writes (sells) call options on that same asset in an attempt to generate. The covered call is a strategy in options trading whereby call options are written against a holding of the underlying Stock. Using the covered call option strategy, the investor gets to earn a premium writing calls while at the same time appreciate all benefits of underlying stock ownership, such as dividends and voting rights, unless he is assigned an exercise notice on the written call and is obligated to sell his shares.

This is often employed when an investor has a short-term neutral view on the asset and for this reason holds the asset long and simultaneously have a short position via the option to generate income from the option premium. An investor who buys or owns stock and writes call options in the equivalent amount can earn premium income without taking on additional risk. The premium received adds to the investor's bottom line regardless of outcome. It offers a small downside 'cushion' in the event the stock slides downward and can boost returns on the upside. This is also known as a buy-write strategy.

Traders brought some Shares and expect the price to rise in the near future. And he is entitled to receive Dividends for the shares he holds in cash market. Covered Call Strategy involves selling of OTM  call Option of the same underlying Stock. The OTM Call Option Strike Price will generally be the price, where trader will look to get out of the stock. He will receive premium amount from writing the Call option.

 

Risk:

Limited, but substantial (risk is from a fall in stock price). Traders will incur losses on his short position when the stock moves beyond the strike price of the call written. This strategy is generally adopted by the people who are Neutral or Moderately Bullish on the Underlying Stock. The maximum loss is limited but substantial. The worst that can happen is for the stock to become worthless.  In that case, the investor will have lost the entire value of the stock. However, that loss will be reduced somewhat by the premium income from selling the call option.

Profit:

Traders will make profits when the stock price shoots up and pockets the premium which he received from shorting the Call Option. If it comes down then he is willing to exit at a point, the exit point is where he has shorted the Call Option. The maximum gains at expiration are limited by the strike price. If the stock is at the strike price, the covered call strategy itself reaches its peak profitability, and would not do better no matter how much higher the stock price might be.  The strategy's net profit would be the premium received, plus any stock gains (or minus stock losses) as measured against the strike price.  

Max Profit = Premium Received - Purchase Price of Underlying + Strike Price of Short Call - Commissions Paid

 

Example:

Tatamotors  is trading around Rs 568 Levels. Lot size of Tatamotors Option is 500.If you think the current level is bullish in nature and buys Tatamotors future @ Rs 568 from the market. You also shorts one 570 Call Option for a premium of Rs. 15.

Your investment will be Rs. 291500

Future-568 *500 =284000

Option-15*500=7500

Case 1: If Tatamotors closes at Rs. 580.You will get a capital appreciation on your investment of Rs. 6000((580-568)*500) plus the Call Option premium you received from writing it i.e. Rs.2500 (15-10)*500).

Your total gain will be Rs 8500(6000+2500)

Case 2: If Tatamotors closes at Rs. 560. You will make a profit from your writing call incur loss from buying future.

In Future=568-560=8*500=RS 4000 LOSS

In Option If it is close the 560 level the 570 Call should be 0 in closing days so you can get the whole writing amount ie short value 15.

Option= 15 -0 =15 *500 =RS 7500

So your total Profit will be =7500-4000=Rs 3500