Covered call
Sounds good? This is what a covered call strategy does.
Pre-requisites for a covered call strategy:
- We need the house, in our case it is shares/stock.
- We need the full house, because we can’t sub-let a part of the house. i.e.
If you own one room in a house, the other room owners might not let you rent out your room.
In our case that is a lot
Capital requirement for a covered call strategy:>
- To own a house, we need to purchase it.
We need the stock in minimum 1 lot quantity(or multiple lots).
How much can a covered call strategy earn you per month?
Let us rework our analogy a bit:
You bought a house, let us assume for 1,00,000.
Found someone who wants to rent it for 2500 or 2.5% for the month but they say if the value of the house goes above 1,05,000 by the end of the month, you will sell them the house for 1,05,000
By the end of the month, you will make:
| Condition | Profit Loss |
|---|---|
| House Price greater than 1,05,000 | Profit: (1,05,000 – 1,00,000) + 2500 = 7500 |
| House Price less than 1,00,000 | Profit: 2500, some unrealized loss. |
Risks
- The house price in our example might drop 10% by the end of the month.
Then we will not be able to find anyone to rent at the price we want. - If the above happens, we have our capital stuck, till the price recovers a bit.
If you were willing to buy and hold a stock, then might as well earn rent on it as long as you can.
Let us get technical about covered calls.
| House Term | Call Option Term |
|---|---|
| House/Property | Underlying |
| Full House/Property not just a room | Lot size i.e. minimum number of shares |
| The person renting will buy at 1,05,000 | Strike Price |
| The renter can only buy the house if price is above 1,05,000 on the date agreed> | The date agreed is: Expiry Date |
| The rent is: 2500 per month | Premium |
These are the basic terms required to understand how to sell(aka write) a call option.
Let us now try to understand a stock/share example to convert our analogy from above into actionable form.
The example is of the Indian stock exchange. If you would like an example of a different country, please tweet at me or leave a comment
I decided that one of the bluechips, RELIANCE INDUSTRIES, is a share I want to buy, it will be our underlying or the house.
Checklist before buying the stock:
- Is Call option available
- Lot size
- Current Market Price of share
How to check if call option is available
Not all shares have an option chain, to check our chosen share does:
- Go to: NSE India website.
- Click the search box, and type in the company/stock name.
- There will be a list showing under the search box, choose the stock.
- If “Derivatives” is not displayed on the page, the stock does not have options.
- If “Derivatives” is displayed on the page, we have an option chain for the stock.
We need the lot size of this share:
- Continuing from above, we click the Derivatives.
- The first item is usually futures, click the “+” sign next to it.
- In the “Trade Information” box there is: “Market Lot”
- The number infront of it is the lot size or the minimum number of shares we need to buy for covered call strategy
Market price of the share:
- Click “Equity”
- Under “Price Information” there is the last traded price.
Here is the information for RELIANCE from the above method for: 05/05/2020
- Call Option available: Yes
- Lot Size: 500 shares
- Current Market Price of share: 1462.65
We go ahead and buy 500 shares of RELIANCE at Rs. 1460 per share.
Now that we have purchased the shares we want to sell a call to earn rent on the shares aka premium.
Choose a strike price and premium(rent from our house analogy)
- Go to: NSE India website.
- Click the search box, and type in the company/stock name.
- There will be a list showing under the search box, choose the stock.
- Click “Derivatives”
- Click “Option Chain”,scroll down, you will see a table as shown below:
- We need to choose the price at which the renter can buy from us. i.e. the strike price.
We want this price to be above our purchase price. - Let us Choose: Strike Price: 1560
- As seen in the table, we can get Rs. 40 per share rent at this Strike Price: 1560
Call you broker and ask them to “Sell 1 lot of Reliance Call Option Strike Price 1560 at Rs. 40”.
We can sell it by logging onto the brokers site but since it is the first time better to call the broker.
Let us see the scenario’s that can happen on expiry of this contract(Date: 28/05/2020):
| Case 1 | Case 2 | Case 3 | |
|---|---|---|---|
| RELIANCE Share Price on 28/05/2020 | 1640 | 1300 | 1450 |
| Buy Price | 1460 | 1460 | 1460 |
| Premium/Rent | 40 x 500 = Rs. 20,000 | 40 x 500 = Rs. 20,000 | 40 x 500 = Rs. 20,000 |
| Strike Price/Price we have agreed to Sell | 1560 | 1560 | 1560 |
| Profit/Loss | (1560 – 1460) x 500 + 20,000 = 70,000 Rs. (Sell – Buy) x Quantity + Rent/Premium |
20,000 (Realized), -160 x 500 = 80,000 (Unrealized) We get the premium/rent, but our stock value is down. |
20,000 (Realized), -10 x 500 = -5000 (Unrealized) We get the premium/rent, but our stock value is down. |
Risks:
- Share price falls significantly, if the share price falls significantly we might not find a strike price suitable for us to earn rent.
If this happens, we are stuck with the stuck till either the price rises and gets close to our purchase price or we decide we are ok to take a loss.
I will be updating this article a bit more, and posting a video explanation in some time. Not to mention other concepts and explanantions.
All information here is for educational/research purposes only, we do not recommend trading.
Thanks a lot for the easy explaination. I am planning to use this strategy once I have enough shares. Is HDFCBANK a good underlying for it?( I have max shares of it as of now)
Also can you provide step by step procedure to deploy it in zerodha.
Hey Anshul, Thank you for reading.
I can’t suggest a direct underlying to you, I am in 100% cash at the moment.
I have all the pictures for how to sell a call on zerodha ready. I will upload an article soon. Sign up for the newsletter to stay updated!
Thanks for the update. Do I need to pledge my shares or do anything different than what I would do in selling a naked call? When the price goes up the broker will automatically settle my call in stocks?
There are two ways to go about it: Pledge your shares(the broker may have charges if you utilize this) or have extra cash available in your account. I prefer to keep extra cash.
The broker will not automatically settle the stocks, at the expiry day if the share is above the strike price you will have to sell your shares and buy the call back or let it expire. If you were to let it expire(I would not suggest this), the settlement price is based on the last half hour price action and might be different from the closing price.
In case 1 wouldn’t the premium of 1560 strike price increase? We will lose if we sell call option and share price keeps increasing. Will you please explain how the 70000 profit is there when there is loss on the premium/rent @1640 ce? Let’s say premium increase to 120 then 120*500=60000? I’m confuse pls explain!
Hi Nishant,
Here is a detailed breakdown of Case I profit loss.
1- The premium will increase for that strike during the month. We are discussing expiry day, 28-5-2020 in the case.
The premium dies down to the intrinsic value as the expiry day comes closer. In the last half hour it, usually, is just the intrinsic price i.e. the difference between strike and current market price.
2- On expiry, we will sell our shares at the market price: 1640. This is now our Sell Price. If the option is not excercised, you can ignore this for now. So we made a total profit on our shares of:
(Sell Price – Purchase price) x number of shares = (1640 – 1460) x 500 = 90000
This is a positive for us. So +90,000
3- Our agreement with the person who paid us rent was: we sell him/her the shares for 1560 if price is above 1560 on expiry. We pay cash instead of delivering shares to this person. We have to give them:
(Current Market Price – Their purchase price from us) x Quantity = (1640 – 1560) x 500 = 40000
This is negative for us. So -40,000
4- We have taken rent/premium of: 40 per share = 40 x 500 = 20,000. This is positive for us. So +20,000
TOTAL PL:
Adding all of the amounts:
Point 2 + Point 3 + Point 4
90,000 + (-40,000) + 20,000 = +70,000
Hope this clarifies everything. Thanks for reading.