Covered call: what’s in it for you

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: 41). If the stock was higher than Rs 41, the trader that held the stock and did not write the 40 call would be gaining more, whereas for the trader who wrote the 40 covered call the profits would be capped.

The covered call strategy works best for the stocks for which you do not expect a lot of upside or downside. Essentially, you want your stock to stay consistent, as you collect the premiums and lower your average cost every month. Also, always remember to account for trading costs in your calculations and possible situations.

Profit potential

The covered call's maximum profit occurs when the stock closes exactly at the strike price of the short call options at expiration of the short call options.

a) Profit calculation

1. If stocks are not assigned (called off) at expiration:

Profit = (value gained in stock + initial price of short call options) / initial value of underlying stock.

Assuming you bought 700XYZ close at Rs 44 and sold 7 contracts of XYZJan45Call for Re 1.

Assuming at expiration, XYZ closes at Rs 44.50.

Profit = (Rs 0.50 + Re 1) / Rs 44 = 3.41%

2. If stocks are assigned (called off) at expiration:

Profit = ((strike price of short call options - initial value of underlying stock) + initial price of short call options) / initial value of underlying stock

Assuming you bought 700XYZ close at Rs 44 and sold 7 contracts of XYZJan45Call for Re 1. Assuming at expiration XYZ, closes at Rs 46.

Profit = ((Rs 45 - Rs 44) + Re 1) / Rs 44 = 4.55%

3. If stocks have dropped in value at expiration:

Profit = (initial price of short call options - (initial stock price - stock price at expiration)) / initial value of underlying stock

Assuming you bought 700XYZ close at Rs 44 and sold 7 contracts of XYZJan45Call for Re 1.

Assuming at expiration, XYZ closes at Rs 43.50.