In a covered call strategy an investor owns the underlying stock but expects that the stock might not rise much in the near term. In this situation the investor can still make an income by selling a call option and receiving a premium from the option buyer. We can recall from the earlier chapters that a call option is sold, when there is a neutral to bearish view on a stock.
In this case the investor choses an out-of-the-money strike to sell a call option.
Mr. Shashank bought Infosys Ltd. for Rs 940 and simultaneously sells a Call option at a strike price of Rs 1000. Which means Mr. Shashank does not think that the price of Infosys Ltd. will rise above Rs. 1000. In case it rises above Rs. 1000, the profit will capped to 80 rupees. Mr. Shashank receives a premium of Rs 10 for selling the Call. Thus net outflow to Mr. Shashank is (Rs. 940 – Rs. 10) = Rs. 930.
If the stock price stays at or below Rs. 1000, the buyer on the other side will not exercise the call option and Mr. Shashank can retain the Rs. 10 premium, which is an extra income. If the stock price goes above Rs 1000, the Call option will get exercised by the Call buyer.
The entire position will work like this:
1) So if the stock has moved from Rs. 940 (purchase price) to Rs. 980, Mr. Shashank makes Rs. 50/- [Rs. 980 – Rs. 940 + Rs. 10 (Premium)]
2) Suppose the price of Infosys Ltd. moves to Rs. 1010, then the Call Buyer will exercise the Call Option and Mr. Shashank will have to pay him Rs. 10 (loss on exercise of the Call Option).
- a) Profit on the underlying 1010-940 = 70
- b) Premium received upfront – 10
- c) Loss in Selling Call – 1000-1010=-10
- d) Total Payoff – 70+10-10=70
|Infosys at Expiry (S)||Payoff from underlying
(Market price – Buy Price)
|Premium Received||Option Payoff
If spot<strike = 0
If spot>strike = strike-spot
You can see from the above table that, Once the underlying price crosses the strike price, profits are capped.