With the markets seeing a downward trend, a strategy with which you can make money even if the market doesn’t rise is covered call (CC). CC provides some protection against falling stock prices, though generally not enough to offset a steep plunge. Experts believe that it’s ?safer than holding the stock outright.?
CC works in this fashion: Holding a long position in an asset and selling call options on that same asset. This strategy is best suited for shares that move up slowly or are stagnant. It is observed that government-owned companies usually form part of any investor’s portfolio. Stocks that give good dividend and are fundamentally sound, form good choices for CC.
How it works
Covered call strategy is two-fold. First, you already own the stock. You will then sell, or write, one call option for each multiple of 100 shares you have (i.e. 100 shares = 1 call, 200 shares = 2 calls, 276 shares = 2 calls).
When using the covered call strategy, you have slightly different risk considerations, than you do if you own the stock outright. You do get to keep the premium you receive when you sell the option, but if the stock goes above the strike price, you have capped the amount you can make. If the stock goes lower, you are not able to simply sell the stock; you will need to buy back the option as well.
There are a number of reasons traders employ covered calls. The most obvious is to produce income on stock that is already in your portfolio. Others like the idea of profiting from option premium time decay. A good use of this strategy is for a stock that you might be holding and that you want to keep as a long-term hold, possibly for tax or dividend purposes. You feel that in the current market environment, the stock value is not likely to appreciate, or it might drop some. As a result, you may decide to write covered calls against your existing position. Alternatively, many traders look for opportunities on options they feel are overvalued and will offer a good return. To enter a covered call position on a stock you do not own, you should buy a call option and simultaneously sell the call. Remember, when doing this that the stock may go down in value. In order to exit the position entirely, you would need to square-off the short position to book the profit and carry forward your long position, with the expectation that stock would go up.
In different situations
On expiry day, if the option is still out of money, it is likely that it will just expire worthless and not be exercised. In this case, you do nothing. If you still want to hold the position, you could “roll out” and write another option against your stock further out in time. Although there is the possibility that an out of the money option will be exercised, this is extremely rare.
If the option is in the money, you can expect the option to be exercised. Depending on your brokerage firm, it is very possible that you don’t need to worry about this; everything will be automatic when the stock is called away. What you do need to be aware of, however, is what, if any, fees will be charged in this situation. You will need to be aware of this so that you can plan appropriately when determining whether writing a given covered call will be profitable.
Let’s look at a brief example. Suppose that you buy 100 shares of XYZ at Rs 38 and sell the July 40 calls for Re 1. In this case, you would bring in Rs 100 in premium for the option you sold. This would make your cost basis on the stock Rs 37 (Rs 38 paid per share – Re 1 for the option). If the July expiration arrives and the stock is trading at or below Rs 40 per share, it is very likely that the option will simply expire worthless and you will keep the premium (in cash). You can then continue to hold the stock and write another option for the next month if you choose.
If, however, the stock is trading at Rs 41, you can expect the stock to be called away. You will be selling it at Rs 40 – the option’s strike price. But remember, you brought in Re 1 in premium for the option, so your profit on the trade will be Rs 3 (bought the stock for Rs 38, received Re 1 for the option, stock called away at Rs 40). Likewise, if you had bought the stock and not sold the option, your profit in this example would be the same Rs 3 (bought at Rs 38, sold at Rs 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.
Profit = (Re 1 – (Rs 44 – Rs 43.50)) / Rs 44 = 1.14%
