Learn with ETMarkets: Options demystified 501–covered calls

Tara felt a surge of delight as she absorbed the wealth of knowledge shared by Maya, an expert in the field of options. She couldn't help but express her heartfelt gratitude to her friend Jay, who had introduced her to Maya. The discussion on options had been extensive, with Maya guiding Tara through each concept with patience and clarity.

From unraveling the significance of options in gauging market sentiment through tools like PCR, option chain analysis, and Max pain, Maya now felt it was the opportune time to acquaint Tara with some commonly employed option strategies embraced by traders.

Link to previous article: https://ecoti.in/Vee1AZ


"Hey Tara," Maya said with a warm smile as they resumed their conversation, finding their seats comfortably in the conference room while savouring their freshly brewed cups of coffee, "let's talk about some options strategies! It might sound intimidating, but I promise it's not as complex as it seems. Let's start with covered calls, which is a relatively conservative options strategy."

Tara eagerly nodded, "Sounds great, Maya! Please continue."

Covered Calls:
"A covered call is a strategy where you own the underlying stock and simultaneously sell a call option on that same stock. By doing this, you're 'covering' the call option with the stock you own. The idea is to generate income from the premiums you receive from selling the call option, providing some downside protection to your stock position", explained Maya.

"Okay, but how does it work?" asked Tara.

"Imagine you have 2000 shares of Infosys, currently priced at Rs.1345 per share," Maya explained. "Now, let's say Infosys recently reached a high of 1358, but you believe the price won't go higher than that anytime soon. In such a scenario, you can employ a strategy by selling a call option. Specifically, you can sell a call option with a strike price of 1360 for the current expiry, which is currently valued at Rs.27 per share."

"To put it into perspective, let's consider selling 5 lots of Infy 1360 call options. Since each lot of Infy consists of 400 shares, the total quantity for 5 lots would be 2000 shares," Maya continued.

"By selling these options, you would receive a premium of Rs.27 per share, totaling an impressive sum of INR 54,000. Now, here's how it works: If the stock price remains below 1,360 at the expiration date, the option expires without value, and you keep the entire premium of Rs.54,000. However, if the stock price surpasses 1,360, the buyer of the option has the right to exercise it, and you would be obligated to sell your shares at Rs.1360 each, regardless of the prevailing market price."

Maya's explanation shed light on the mechanics of the strategy, making it easier for Tara to understand the potential outcomes and consequences involved.

"Wow, that's really fascinating!" Tara exclaimed; her curiosity piqued. "So, let me get this straight. If the price of the stock drops or stays below 1,360, I can easily make a cool 54,000 by selling a call option. But what happens if the price keeps rising? Won't I be missing out on potential profits?"

Maya replied. "Absolutely right, Option writing does come with the risk of unlimited loss. However, in this scenario, since you already own the underlying stock, it acts as a safety net, protecting you from that unlimited loss. But, keep in mind, your profits will be limited to the strike price plus the call premium. However, the real beauty of this strategy lies in having a good grasp of price action. By identifying potential resistance levels on the upside, you can strategically sell call options above those levels."

She added, "Another fantastic aspect of the covered call strategy is its usefulness in a buy-and-hold portfolio. If you have some stocks that aren't performing as well, implementing the covered call strategy can generate regular returns on those stocks. It's a fantastic way to make the most out of your portfolio."

Tara's voice filled with anticipation as she declared, "I think I've grasped the concept, and I can't wait to try it out in my own portfolio and see how it performs. But, I'm also really eager to learn about other option strategies. It feels like a whole new world of possibilities."

To be Continued.

(The author is CEO Yubha.com, TradingHeads.com)

(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)