Covered Call Strategy in Options Trading – How It Works | 2026

The Covered Call Strategy: How to "Rent Out" Your Stocks for Monthly Income

Most investors buy a stock and then... wait. They wait for the price to go up, or they wait for a dividend. But what if the stock does nothing? What if it just moves sideways for months?

In a flat market, your money is dead weight. But smart traders use a strategy to generate regular income from these "lazy" stocks. It is called the Covered Call Strategy.

Think of it like owning a house. You can hope the property value goes up (Capital Appreciation), or you can rent it out to earn monthly cash (Rental Income). Covered Calls are like collecting rent on your shares.

Here is everything you need to know about the covered call strategy, how it works, and the risks involved.

What is a Covered Call?

A Covered Call is an options strategy where you:

1. Own the Stock: You hold a long position in a stock (e.g., 100 shares of Reliance).
2. Sell a Call Option: You sell (write) a Call Option on that same stock.

By selling the option, you collect a cash payment upfront called the Premium.

• Why is it called "Covered"? Because you already own the shares. If the stock price skyrockets and you are forced to sell, you have the shares ready to deliver. You are "covered" against the risk of having to buy expensive shares from the market to fulfill the contract.

How the Covered Call Strategy Works (Example)

Picture this: you’ve got 100 shares of Stock A, each going for ₹1,000. You think the price won’t shoot past ₹1,050 this month—maybe it’ll nudge up a bit, maybe not. Here’s what you do. 

First, just hang on to your 100 shares. Then, you sell a call option with a strike price of ₹1,050. The buyer pays you a premium of ₹20 per share. That’s ₹2,000 straight into your account (100 shares times ₹20). You keep that cash, no strings attached—regardless of what the stock does next.

The 3 Scenarios at Expiry:

Why Use the Covered Call Strategy?

1. Generate Consistent Income

This is the primary goal. If a stock isn't moving, selling OTM (Out-of-the-Money) calls allows you to create your own "dividend" every month.

2. Reduce Your Cost Basis

Every time you collect a premium, you effectively lower the purchase price of your stock.

• Example: Bought at ₹100. Collected ₹2 premium. New cost basis = ₹98.
• If the stock falls to ₹98, you are still break-even, whereas a normal investor would be at a loss.

3. Discipline

It forces you to sell at a profit target. If you sell a call at ₹1,050, you are mentally prepared to exit at that price, removing greed from the equation.

The Risks: What’s the Catch?

No strategy is risk-free. Here are the downsides:

• Capped Upside (The "FOMO" Risk):If the stock rallies to ₹1,200, you still have to sell at ₹1,050. You make a profit, but you miss out on the "super profit." This is the opportunity cost.
• Not a Protection Against Crashes:If the stock crashes to ₹800, the ₹20 premium you collected won't save you. You will still suffer a loss on your main stock holding (though slightly less than a regular investor).
• Assignment Risk:If the stock crosses your strike price, your shares will be sold (called away). You must be emotionally ready to part with your shares.

When Should You Use This Strategy?

The covered call strategy is best used in a Neutral to Slightly Bullish market.

• ✅ Do it when: You think the market is consolidating or moving up slowly.
• ❌ Avoid it when: You expect a massive breakout (you will limit your profit) or a market crash (you need better protection, like a Put Option).

How to Pick the Right Strike Price (The Delta Rule)

Beginners often ask: "Which strike price should I sell? The one close to the current price or far away?" Professional traders use Delta to decide.

• Aggressive Income (At-The-Money):
  • Strike: Close to current price (Delta ~0.50).
  • Premium: High.
  • Risk: High chance of your shares being sold. Use this if you are okay with selling the stock.
• Conservative Income (Out-Of-The-Money):
  • Strike: Higher than current price (Delta ~0.20 to 0.30).
  • Premium: Lower.
  • Benefit: You keep the stock unless it rallies significantly. This is the "Sweet Spot" for most investors.

Rule of Thumb: Look for a strike price with a 0.30 Delta. This roughly means there is only a 30% chance the option will be exercised against you.

What if the Stock Rallies? (The Art of "Rolling")

Imagine you sold a Call at ₹1,050, but Stock A flies to ₹1,080. You are now "In the Money," and you risk losing your shares at a lower price. You have two choices:

1. Let it go: Let the shares be sold at ₹1,050. Take your max profit and move on.
2. Roll Up and Out:
   • Buy Back your existing loss-making option.
   • Sell a new option for next month at a higher strike price (e.g., ₹1,100).
   • Result: You keep your shares for another month and give the stock more room to grow.

The "Wheel Strategy": The Infinite Loop

This is an advanced lifecycle strategy that combines Selling Puts and Selling Calls.

1. Step 1: Sell a Cash-Secured Put.
   • You want to buy Stock A at ₹950 (Current price ₹1,000).
   • You sell a ₹950 Put. If the stock falls, you are forced to buy it at ₹950. (Great! You wanted it anyway).
2. Step 2: Start the Covered Call.
   • Now that you own the stock, you Sell Covered Calls on it every month to earn rental income.
3. Step 3: Repeat.
   • If your shares get called away (sold) due to a rally, you go back to Step 1 and sell Puts again.

Tax Implications in India

Income from selling options (premiums) is generally treated as Business Income (Non-Speculative) or Capital Gains depending on whether you are classified as a trader or an investor.

• For Traders: The premium received is added to your business turnover.
• For Investors: If you hold the stock as an investment, the premium can sometimes be considered capital gains, but tax rules here are complex.
• Advice: Most active F&O traders treat this as Business Income to claim expenses.

Conclusion

The covered call is one of the safest option strategies available because it does not involve leverage on the loss side (since you own the stock). It is an excellent tool for long-term investors who want to squeeze extra returns out of their portfolio while waiting for capital appreciation.

Next Step: Check your portfolio. Do you have 100 shares (or 1 lot) of a stock that has been sleeping for months? That might be your candidate for a covered call.

FAQs

1. Do I need to own 100 shares to do a Covered Call? 

In the US market, yes (1 contract = 100 shares). However, in India, you must own shares equivalent to one full F&O Lot Size.

• Example: To do a covered call on Reliance, you need 500 shares (1 Lot). For Tata Steel, you might need 5,500 shares. You cannot do this with odd quantities like 50 or 75 shares.

2. What happens if the stock price rises above my Strike Price?

 If the stock price at expiry is higher than your Strike Price, your option is "In the Money."

• Physical Settlement: You are obligated to sell your shares to the buyer at the Strike Price.
• Result: You keep the premium and the profit up to the Strike Price, but you miss out on any gains above that price.

3. Is the Covered Call strategy risk-free? 

No. While it reduces risk, it does not eliminate it.

• Downside Risk: If the stock price crashes significantly (e.g., drops 20%), the small premium you collected (e.g., 2%) will not cover the loss in your stock holdings.

4. Can I use Pledged Shares to sell the Call Option? 

Yes! This is a major advantage.

• You can pledge your holdings with your broker to get Collateral Margin.
• You can then use this margin to sell (write) the Call Option. This way, you don't need to add extra cash to your Trading App (firstock) account to initiate the trade.

5. When is the best time to enter a Covered Call?

 The ideal time is when:

• You are moderately bullish or expect the stock to stay sideways.
• Implied Volatility (IV) is high (premiums are expensive), giving you more income.
• Avoid: Do not sell calls if a major event (like a budget or earnings result) is expected to cause a massive price spike.