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Covered Calls Explained with Reliance Industries (RIL) Example

Let's say you own shares of Reliance Industries (RIL) and want to earn some extra income on your existing stock. Covered calls can be a strategy to do this.

What is a Covered Call?

In a covered call, you sell call options on the stock you already own (RIL in this case). A call option gives someone the right, but not the obligation, to buy your shares at a certain price (strike price) by a certain time (expiry date).

Understanding the Options

  • Your Goal: Earn income on your RIL shares.
  • Strike Price: This is the price at which you're willing to sell your RIL shares if the buyer exercises the call option. Typically, it's chosen a bit above the current market price (say, RIL is at 2838 rupees, you pick 2900 rupees).
  • Number of Contracts: Each contract usually covers 100 shares. You decide how many contracts to sell based on your income goals and risk tolerance.

Possible Outcomes:

  1. Stock Price Stays Below Strike Price (Expiry): Good news! The call option expires worthless, and you keep the premium you received for selling it. This is extra income on top of any dividends you get from RIL.

  2. Stock Price Goes Above Strike Price (Expiry): The buyer might exercise the option, forcing you to sell your shares at the strike price. You earn the premium, plus the strike price, but miss out on any profits if the stock goes much higher.

  3. Stock Price Goes Down: Not ideal, but you still keep the premium from the call option, which helps offset some of the loss.

  4. Stock Price Soars: This can be frustrating. You're stuck selling at the strike price, even if the stock price goes much higher. But the premium adds some cushion.

Example:

Imagine you sell 3 covered call contracts for RIL (300 shares total) with a strike price of 2900 rupees. Let's say the premium is 120 rupees per share.

  • Income from Premium: 120 rupees/share * 100 shares/contract * 3 contracts = 36,000 rupees

This 36,000 rupees is your immediate earnings from selling the call options. Remember though, the actual profit or loss depends on how the stock price behaves.

Covered calls are a way to generate income from your stocks, but they limit potential gains and come with some risks. Consider these factors before using this strategy.

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