Covered call strategy explained with a worked example
Hold the shares, sell a call on them: premium income now, in exchange for capping the upside at the strike.
A covered call means you own a stock and sell a call option on the same stock. The premium from the call is extra income on a holding you planned to keep anyway. It also lowers your effective purchase price.
In return you give up the upside above the strike. If the stock rallies past it, the call buyer takes the gain beyond the strike. The call is 'covered' because the shares you hold can meet the obligation, unlike a naked call where the seller owns nothing.
Worked example: payoff at expiry
Illustrative numbers, not market prices. You hold shares of a stock bought at ₹1,000. You sell the 1,050 call expiring this month for ₹20. Figures are per share; multiply by the lot size the exchange sets for one contract.
900
Shares P&L
-100
Short 1,050 call
+20
Net P&L
-80
980
Shares P&L
-20
Short 1,050 call
+20
Net P&L
0
1,000
Shares P&L
0
Short 1,050 call
+20
Net P&L
+20
1,050
Shares P&L
+50
Short 1,050 call
+20
Net P&L
+70
1,100
Shares P&L
+100
Short 1,050 call
-30
Net P&L
+70
1,200
Shares P&L
+200
Short 1,050 call
-130
Net P&L
+70
| Stock at expiry | Shares P&L | Short 1,050 call | Net P&L |
|---|---|---|---|
| 900 | -100 | +20 | -80 |
| 980 | -20 | +20 | 0 |
| 1,000 | 0 | +20 | +20 |
| 1,050 | +50 | +20 | +70 |
| 1,100 | +100 | -30 | +70 |
| 1,200 | +200 | -130 | +70 |
Breakeven, maximum profit and maximum loss
- check_circleBreakeven = purchase price minus premium = 1,000 minus 20 = ₹980.
- check_circleMaximum profit = (strike minus purchase price) plus premium = 50 plus 20 = ₹70 per share, reached at or above 1,050.
- check_circleMaximum loss = purchase price minus premium = ₹980 per share, if the stock falls to zero. The premium cushions a fall by only ₹20.
- check_circleBelow 1,050 the position moves rupee for rupee with the stock, shifted up by the premium. Above 1,050 it is flat.
Ideas the exam attaches to this strategy
- Covered vs naked call
- A covered call writer owns the underlying shares. A naked call writer does not, and faces losses that keep growing as the price rises.
- Synthetic short put
- The NISM workbook's label for a covered call. Long stock plus short call gives a payoff shaped like a short put at the same strike: capped gain, large downside.
- Strike choice
- A strike close to the current price earns more premium but caps the gain early. A far strike earns less premium but leaves more room for the stock to rise.
- Assignment
- If the call ends in the money at expiry, it is exercised and the writer is assigned: the obligation to sell at the strike falls on them. Options in India are European style, so this happens only at expiry.
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Covered call vs protective put
Both start with shares you already own. A covered call SELLS a call to earn income and caps the upside. A protective put BUYS a put to cap the downside and costs premium. The workbook calls them a synthetic short put and a synthetic long call respectively, and exam options often swap the two.
How Series VIII tests this
The common question gives a purchase price, a strike and a premium and asks for the net payoff at one expiry price, the maximum profit or the breakeven. The traps: forgetting to add the premium to the capped gain, adding the premium to the purchase price instead of subtracting it for breakeven, or calling the maximum loss 'limited to the premium'.
The workbook also asks which single option a covered call resembles. The answer is a short put at the same strike, not a long call. Remember the shape: a ceiling on top, open floor below.
FAQs
What is a covered call strategy?expand_more
Holding a stock and selling a call option on it. You earn the premium as income, and in return give up any rise in the stock above the strike price.
How do you calculate the breakeven of a covered call?expand_more
Stock purchase price minus the premium received. Shares bought at ₹1,000 with a ₹20 premium break even at ₹980.
What is the maximum loss in a covered call?expand_more
The purchase price minus the premium, if the stock falls to zero. The strategy reduces downside only by the premium received, so most of the stock's risk remains.
Why is a covered call called a synthetic short put?expand_more
Because long stock plus a short call produces the same payoff shape as selling a put at that strike: a fixed maximum gain and a loss that grows as the price falls.
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