Let’s consider that you are an investor.
You own shares in a company that you may feel may rise but not much in the near term (or at best stay sideways). You would still like to earn an income from the shares though.
Covered Call is a strategy in which an investor SELLS a Call option on a stock he owns—netting him a premium. The Call Option is sold usually in an OTM ( Out of The Money) call. The Call would not get exercised unless the stock price increases above the strike price. Till then the investor in the stock (Call seller) can retain the Premium with him. This becomes his income from the stock. This strategy is usually adopted by a stock owner who is Neutral to moderately Bullish about the stock.
An investor buys a stock or owns a stock which he feels is good for medium or long term but is neutral or bearish for the near term. At the same time, the investor does not mind exiting the stock at a certain price (target price).
The investor can sell a Call Option at the strike price at which she/he would be fine exiting the stock (OTM strike). By selling the Call Option, the investor earns a Premium. Now, the position of the investor that of a Call Seller who owns the underlying stock.
If the stock price stays at or below the strike price, the Call Buyer (refer to Strategy 1) will not exercise the Call. The Premium is retained by the investor. In case the stock price goes above the strike price, the Call buyer who has the right to buy the stock at the strike Price will exercise the Call option. The Call seller (the investor) who has to sell the stock to the Call buyer, will sell the stock at the strike price. This was the price which the Call seller ( the investor) was anyway interested in exiting the stock and now exits at that price. So, besides the strike price which was the target price for selling the stock, the Call seller (investor) also earns the Premium which becomes an additional gain for him. This strategy is called as a Covered Call strategy because the Call sold is backed by a stock owned by the Call Seller (investor). The income increases as the stock rises, but gets capped after the stock reaches the strike price.
When to Use: This is often employed when an investor has a short-term neutral or moderately bullish view on the stocks she/he holds. She/he takes a short position on the call option to generate income from the option premium. Since the stock is purchased simultaneously with writing (selling) the Call, the strategy is commonly referred to as “buy-write.”
Risk: If the stock price falls to zero, the investor loses the entire value of the Stock but retains the premium because the Call will not be exercised against him.
Therefore, Maximum risk= Stock Price Paid—Call Premium.
Upside capped at the Strike Price plus the Premium received. So, if the stock rises beyond the Strike price the investor (Call seller) gives up all the gains on the stock.
Reward: Limited to (Call Strike Price—Stock Price paid) + Premium Received
Breakeven: Stock Price paid—Premium received.
Mr. A bought XYZ Ltd. for Rs. 3850 and simultaneously sells a Call option at a strike price of Rs. 4000. Which means Mr. A does not think that the price of XYZ Ltd. will rise above Rs. 4000. However, in case it rises above Rs. 4000, Mr. A does not mind exiting the stock at Rs. 4000 (TARGET SELL PRICE= 3.90% return on the stock purchase price).
Mr. A receives a premium of Rs. 80 for selling the Call. Thus, net outflow to Mr. A is Rs. 3850—Rs. 80= Rs. 3770. He reduces the cost of buying the stock by this strategy. If the stock price stays at or below Rs. 4000, the Call option will not get exercised and Mr. A can retain the Rs. 80 premium, which is an extra income. If the stock price goes above Rs. 4000, the Call option will get exercised by the Call buyer.