Before diving deep into the Covered Calls strategy, here is a quick rundown of the Derivatives market and hedging.
A derivatives market is “derived” from other forms of underlying assets such as stocks, stock indices, currency, bonds, commodities, and precious metals.
Several financial instruments are traded in this market, including Futures contracts, Forwards, Swaps, and Options. This type of exchange allows traders/investors to hedge their profits in a consolidated or uncertain market.
What Are Options In the Derivatives Market?
Options are a subcategory of derivatives financial instruments that gives you an “option,” – meaning you have the right to buy or sell the underlying asset but not an obligation. In exchange for this “right,” the buyer pays a “premium” for the trade.
As a trader, the Options leverage your position in an asset at a discounted price than buying the shares of the original asset. Basically, options can also be used to hedge or as a risk aversion strategy for a healthy portfolio.
Rather than considering it as a speculative market, Options traders analyze two main performance parameters–
- The Option’s daily trading volume.
- Open interest- total number of outstanding derivative contracts that have not been settled.
These two factors indicate whether the Option Strategy is favorable in the long run.
Based on the market trend, two main types of instruments in Options are the CALL Option and PUT Option.
What Is a CALL Option?
In simple terms– the CALL option works in a Bullish market. When the trader expects the market to be on an upward trend, they buy a CALL option which gives them the right but not the obligation to purchase the underlying security. You can buy this CALL option only at a predetermined Strike Price on or before the Options contract expires.
Bottom Line: The CALL option is used to reduce the cost of purchase so that you have higher chances of making profits.
Buying a CALL option becomes profitable when its underlying security rises in price. Hence, CALL has a positive delta– a parameter that denotes the change in the Option’s price or premium due to the difference in the Underlying futures price.
NOTE: A CALL option has unlimited upside potential, and the maximum loss margin is the premium you paid to buy that CALL Option.
What Is Covered Calls Strategy In Options Trading?
Now that we have understood the basic mechanisms of a CALL option, we can trade these derivative instruments using various strategies. Sometimes a rangebound market can make a trade uncertain.
Hence, we need a strategy that secures a trade when you expect the market to be bullish for the underlying stock but also feels that the stock won’t yield much rise until the CALL contract expires.
When the underlying stock is trading in a limited price range, it becomes difficult to pick up substantial profit. To “cover” this range, the COVERED CALLS strategy is used.
A Covered Call uses a two-part strategy–
Part 1: Stocks are purchased or owned (underlying assets)
Part 2: Entering the Options market and selling the corresponding CALL option on a share-for-share basis.
Maximum Gain: Limited (since the market is probably rangebound)
Maximum Loss: Considerable (since you purchased the underlying stock)
Break Even Point: {Purchase Price of the stock – Premium received by selling the CALL option}
EXAMPLE:
Step 1: Suppose you bought 100 shares of ABC stock trading at $78 at the start of July.
Step 2: Then you write (sell) a $88 OTM CALL option of the ABC stock for $5.
Step 3: Let’s tally your account so far–
You Paid: $78×100= $7800 for purchasing the underlying stock.
You Received: $5×100=$500 from the premium for selling the CALL option.
Step 4: Let us see three possible scenarios on the expiration date of the Options contract.
| The stock rallied to $88 | The Stock rallies above the strike price, say $98 | The Stock rallies below the strike price, say $68 |
| Profit: [(88-78)x100 + 500] = $1500 (maximum) | The writer has to sell his 100 shares to the Call buyer (88-78)x100= 1000 And gains a premium of 500 = $1500 (maximum possible profit in covered CALL) | Loss: [(68-78)x100 + 500] = -$500 (offset loss) |
As you can see, the profit becomes constant after the break-even point, but the loss incurred can go on further as the underlying stock shows a bearish trend.
ADVANTAGES:
- Only use this strategy when your stock price becomes stagnant to earn an additional income through CALL premiums.
- You can offset loss if the stock drops in value.
DISADVANTAGES:
You can lose your underlying stock if its price rises above the Strike price of the short CALL option.
What is your take on this strategy? Are you willing to take the risk during a consolidated market? Let us know in the comments section below.
