WHAT IS COVERED CALL AND COVERED PUT?

Last Updated: 9 Nov 2023

As the name suggests, covered call and covered put are two classic examples of a covered strategy where your derivatives position is backed by a cash market underlying position. So, what is a covered call, and what is a covered put in options trading? We will first start by looking at covered call options and then follow it up with a look at covered put options to understand both these sister strategies. Remember, covered put is also called married put and these are normally used interchangeably so don’t get overly confused about the same.

WHAT IS A COVERED CALL?

Let us start by understanding that a covered call will only work when one side is a cash market position because your downside risk is open. A covered call is not exactly an instance of a limited risk strategy. The covered call has a very simple purpose. The covered call options strategy is used to reduce the cost of holding a stock when it does not move for a long time. This is such a common problem for all of us. Instead of letting the investment remain idle, you can sell higher call options, earn the premium and reduce the cost of holding the stock.

Let us look at this more practically. Just assume that you bought stock intending to hold from a long-term perspective. After you bought the stock, the price of the stock came down but you continue to be fairly confident of the long-term prospects. But even as you hold your conviction, there is something you can surely do here. You can sell slightly higher calls that are likely to expire worthless so that the premiums become your income. In the process, the premium income on these OTM call options will serve to reduce the cost of holding the stock and also bring down the cost of purchase instead of just idling in the Demat account.

How does the pay-off work for a covered call option? There are two kinds of price movements you need to be wary of. As long as the stock is stagnating around current levels or up to the higher call strike price of the call you have sold, you have not much to worry about. You are anyways going to earn the premium. If the price shoots above the strike price, then the losses on the call that you have sold can be unlimited. But that is fully covered by your stock position, where you are already holding delivery so not much to worry about. However, on the downside, your risk is fully open and you need to be wary of that. Hence, this strategy is best only when you are sure that you can hold on to the stock and you must not try this on speculative futures position, although it may look quite enticing.

Illustration of covered call options

An investor buys a stock in the cash market at Rs.800 and sells an Rs.820 call option at Rs.8. Let us see how the payoffs pan out at different price levels of the stock. The table below captures the pay-off and the logic of the profit or loss that you get.

Spot Prices	Long Price	Call Strike	Call Prem Read	ITM/OTM	P/L on Spot	P/L on Option	Net P / L
740	800	820	8	OTM	-60	0	-52.00
760	800	820	8	OTM	-40.00	0	-32
780	800	820.00	8	OTM	-20	0	-12
800.00	800	820.00	8	OTM	0	0	8
820	800	820	8	ATM	20	0.00	28
840	800	820.00	8.00	ITM	40	-20	28
860.00	800.00	820	8	ITM	60	-40.00	28

Let us just illustrate two such specific cases. When the price of the stock goes down to Rs.740, there is a notional loss on the stock you are holding as you have bought the stock at Rs.800 price levels. However, the Rs.820 call that you sold will expire worthlessly and you get to keep the entire premium of Rs.8. Hence you lose notionally Rs.60 on the spot position but gain Rsl.8 on the call option sold so your net notional loss is Rs.52.

Let us look at when the price of the stock goes down to Rs.860, there is a notional gain on the stock you are holding as you have bought the stock at Rs.800 price levels. However, the Rs.820 call that you sold will now become deep in the money and mount your losses while you just earn the premium of Rs.8. Hence you notionally gain Rs.60 on the spot position but lost Rs.32 (860 – 820 – 8) on the short call position. This results in a net profit of Rs.28, which is also the maximum profit on the covered call strategy.

Key takeaways from the covered call strategy illustration?

• The maximum profit on the covered call strategy as we can see is Rs.28. That is obvious from the table, but how does this max profit come about? That is the sum of the gap between the strike price and spot price (820-800) plus the option premium of Rs.8 received. However, high as the stock price goes, your profit ceiling is Rs.28.
• The point to note is that in a covered call, the maximum profit always arises at the strike price at which the call is sold. Above that particular point, any profit on the spot position is negated by losses on the call option sold. It kind of neutralizes each other.
• On the downside, as you can see from the table above, the losses can be unlimited. Hence this strategy must only be adopted in the case of stocks with strong fundamentals and where you have the conviction to hold for the long term. You must not attempt this strategy on speculative stocks.
• The breakeven point for the covered call strategy is Rs.792. How did we arrive at this number? Your cost price of the stock is Rs.800 and you have earned Rs.8 as a premium. So, your profit starts kicking from above Rs.792, which is your break-even point. The strategy is to increase your profits between the levels of Rs.792 and Rs.820. From that point, the profits stagnate at the same level.

COVERED PUT STRATEGY (MARRIED PUT)

The covered put strategy or married put strategy is the mirror image of a covered call strategy. Just as the covered call is used to reduce the cost of holding a long position, the covered put or married put is used to reduce the cost of a short position. Assume that you sold a stock but after you sold the stock, the price of the stock went up further but you continue to be negative on the stock. You can sell slightly lower puts that are likely to expire worthless so that the premiums become your income.

Let us take a practical illustration of how this covered put strategy or married put strategy will work in practice. We assume an investor who has sold a position and then covers it up with a covered put strategy.

Illustration of a Covered Put Strategy or Married Put Strategy

An investor sells stock in the cash market at Rs.800 and sells an Rs.780 put option at Rs.8. Let us see how the payoffs pan out.

Spot Prices	Sell Price	Put Strike	Call Prem Read	ITM/OTM	P/L on Spot	P/L on Option	Net P / L
740	800	780	8	ITM	60	-40	28.00
760	800	780	8	ITM	40.00	-20	28
780	800	780.00	8	ATM	20	0	28
800.00	800	780.00	8	OTM	0	0	8
820	800	780	8	OTM	-20	0.00	-12
840	800	780.00	8.00	OTM	-40	0	-32
860.00	800.00	780	8	OTM	-60	0.00	-52

Key takeaways from the above illustration of covered put or married put strategy

• The maximum profit on the covered put or married put strategy as we can see is Rs.28. That is obvious from the table, but how does this max profit of Rs.28 come about? That is the sum of the gap between the spot price and strike price (800-780) plus the option premium of Rs.8 received. However, as low the stock price goes, your profit ceiling is Rs.28.
• The point to note is that in a covered put strategy, the maximum profit always arises at the strike price at which the put is sold. This is a standard feature of the covered put strategy. Below that particular point, any profit on a short position is negated by losses on the put option sold. It kind of neutralizes each other.
• On the upside, as you can see from the table above, the losses can be unlimited. Hence this strategy must only be adopted in the case of stocks where you have the Demat delivery to sell. Selling futures or borrowing and selling are not great ideas for covered put strategy. You must not attempt this covered put strategy ever on speculative stocks.
• The breakeven point for the covered put strategy or the married put strategy is Rs.808. How did we arrive at this number? Your cost price of a short stock is Rs.800 and you have earned Rs.8 as a premium. So, your profit starts kicking from below Rs.808, which is your break-even point. The strategy is to increase your profits between the levels of Rs.808 and Rs.780. From that point of Rs.780 and lower, the profits on the covered put strategy will stagnate at the same level.

That in a nutshell is the gist of the covered call strategy and the covered put strategy

WHAT ARE THE COVERED OPTIONS?

Covered options are options that are covered by an underlying cash market or underlying position in real asset terms. They are the opposite of naked options positions.

WHAT ARE COMMODITY OPTIONS?

Commodity options are options on commodities like industrial metals, gold, silver, and crude oil. Options on commodities in India are not options on commodities but options on futures on the commodities.

Frequently Asked Questions

Is trading in covered put and call profitable?

Normally, covered calls positions and covered put positions are not intended to make profits on their own but the intent is to protect the losses and reduce the cost of the strategy. But at times, such strategies do turn out to be extremely profitable.

Can you sell covered calls and puts at the same time?

Yes you can but ensure that you are clear about where you stand on a net basis. Very complex strategies can be too expensive and unnecessarily confusing.