The Covered Call Strategy: Leveraging Bullish Potential for Enhanced Returns
Apply the strategy when you have a bullish view on an underlying asset.
The covered call strategy is very popular among the professional trader, as this strategy requires a good amount of margin, no reatail traders are able to apply covered call strategy.
When to use Covered Call Strategy?
The Covered Call strategy is generally implemented when an investor holds a bullish view on the underlying asset but wants to generate additional income from the position. It involves owning the underlying asset and selling a call option against it.
Explanation: Assume you are bullish on ABC Ltd and it is currently trading at 500/-. The lot size of ABC Ltd is 1500 and the Strike Difference is 10/-. Now normally what professionals do, is, they buy 1500qty of ABC Ltd in equity segment and write a call of 510CE or merely 520CE. Let us assume you have sold 1 lot of 520CE at 7/-
ABC Ltd cmp =500/-
Buy 1500 Qty of ABC Ltd at 500/-
Sell ABC Ltd 520CE at 7/-
Lot Size =1500
Intrinsic Value of 520CE=0
Time Value of 520CE=7/-Now let us calculate the probable out comes.
If ABC Ltd move up: You will make money from your equity and your options writting will give you loss, so question is how you will make money from this covered call strategy? Here you are limiting your profit potential. But probability of making profit is 2 times higher than loosing money from covered call strategy. Question is how? Let's discuss the probability.
ABC Ltd Close at your strike price (520) on the day of Expiry: You will gain 20/- from your equity + 7/-
Profit from equity= 1500*20=30000/-
Profit from 520CE=1500*7=10500
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Gross profit =40500/
As you have received premium of 7/- for writting the 520CE, you will not lose a single penny if ABC Ltd close at or below 527 on the day of expiry. As the Breakeven for seelling a Call Options = Strike price + Premum Received. But once ABC Ltd cross 527 loss will start for your call selling (On the day of expiry only, but if cross 527 far before expiry day then losses may start for call writting). In other word you can say you are safe till 527 on the day of expiry. So maximum gain is possible is only 27/-
ABC Ltd Close above your strike price (520) On the day of Expiry: As mentioned earlier thet you are safe till 527, once price reach 527, you will earn 1/- for your equity buying and you will lose 1/- for your options selling for every 1/- upside movement, so your maximum gain from this strategy is only 27/- so if the ABC Ltd move up unlimitted still your maximum profit will be 27/- only. In other word you can say when you are very bullish on an underlying that time Covered call strategy is not a good strategy. Instead when Up Side is limitted for an underlying but chances of fall is also low then covered call is a very good strategy.
If ABC Ltd goes down: You have received a premium of 7/- for writting 520CE, it means if ABC Ltd close at 500/- (Your purchased price of equity) on the day of expiry, still you will make a profit of 7/- from the strategy.
And the lowerside Breakeven = Equity Purchased rate - Premium received
= 500 -7
= 493
It means if ABC Ltd close below 493 you will lose money, for every 1/- decline you will lose 1500/- Here you can do two thing,
1) Exit from the strategy while it is going against your analysis and book a minor loss.
2) You can sell more call options as well as underlying going down, but in that case huge capital requires.
It's a very good staretgy indeed, but understanding of the direction and volatility is the most important thing. When you are bullish and there are no doubt or very less doubt about the trend then only think to create this strategy, besides that remember volatility of the underlying should be less. So the depth knowledge of technical analysis is require for this option trading strategy. In dronakul I focus mainly on price action technical analysis for any options strategy.
I normally focus on this strategy when Nifty is mildly bullish and that time a stock creating buying opportunity in chart patter I go for Covered call strategy. That time my thinking is "Now, neither Nifty will able to support this stock for big up move nor it will push it down" and obviously the result of the company is not there till the expiry another thing I focus before this strategy.