Trading Strategies – Covered Calls

Covered Calls

In the last article, we discussed about strategies which you could use if you are bearish. Covered Calls is a strategy which could also incidentlally fit into a bearish orientation.

What are Coverd Calls?

Covered Calls are strategies where you have sold a Call. As a seller, you are exposed to unlimited losses. However, you hold the underlying security as a result of which, if the situation arises, you can always deliver the underlying and thus avoid such unlimited losses.

Can you give me an Example?

You are holding Satyam which is currently quoting at Rs 230. You are bearish on Satyam and you believe it might touch Rs 200 in the next 30 days. You therefore sell a Call with Strike Price 220 for Rs 15. You have earned this Income of Rs 25 as a Seller.

Now if Satyam were to move up (rather than down as per your expectation) you will face losses. For example, if Satyam moves to Rs 270, you will, as a seller, pay Rs 50 (differene between the Satyam price and the strike price).

However, you are not affected by this loss because, as a holder of Satyam itself, your holding has appreciated from the current level of Rs 230 to Rs 270 which has generated a profit of Rs 40.

Thus, the loss on the Call has been offset with the rise in the price of the underlying security. Your overall profit is Rs 15 computed as follows:

  • Rs 25 as Income from Sale of the Call
  • Rs 40 as appreciation in Satyam shares
  • Less Rs 50 payout on the exercise of the Call.

When should I be interested in a Covered Call?

There are several situations which might make this product interesting. The classic one is where you hold a share which you like and would like to hold it in the medium to long term. You have no inclinations of selling it. However, you do believe that in the short term, there is no great potential for appreciation.

In fact you believe that the share will either stay where it is (neutral view) or it might even fall in price.

In this situation, you wonder how you can make money even when holding on to the share itself. For example, you hold Infosys which is currently quoting at Rs 3,400. You love Infosys and would like to keep it forever. However, in the short run, you believe Infosys will either fall or stay around the Rs 3,400 mark.

Infosys 3,400 strike one month calls are currently quoting at Rs 150. If you sell these calls, you can generate an equivalent income. If your view is correct, you get to retain the entire Rs 150 with no costs. 

What if my view is wrong?

If your view is wrong (and Infosys moves up), you still do not lose much because the loss on the Call will offset the gain on the appreciation of the share itself. You will still make your gain of Rs 150.

The loss will be a loss of ‘opportunity’ in the sense that had you not sold the Call, you could have gained more in case of a substantial rise in the price of Infosys. The following table will give you a clear view.

Infosys Price Income on Call Appreciation on Shares Net Profit Opportunity Loss
3300 150 -100 50 0
3400 150 0 150 0
3500 150 100 150 0
3600 150 200 150 50
3700 150 300 150 150
3800 150 400 150 250

How are the above figures computed?

We are examining the situation from various possible levels of Infosys closing prices after a month. The appreciation is the income you would have earned had you not sold the Call. It could be depreciation also in the first case.

The actual income you earned was Rs 150 from the sale of the Call. The appreciation from the share would offset the loss on exercise of the Call and would set off against each other.

Opportunity loss would arise if the share appreciates substantially and your income is limited to Rs 150. This column is worked out as the difference between gain on appreciation less income from sale of call. Negative differences are not considered as there is no Opportunity loss in these cases.

How much can I earn?

As a simple example, suppose you earn Rs 150 per month for 12 months of the year on Infosys, that would work out to Rs 1,800 per annum i..e. 55% of the share price itself. These can become much more powerful than a dividend stream and can considerably enhance your earnings.

Where else can this strategy be used?

You can use this Strategy to protect your position in two cases. One – you have sold a Call but you now believe that selling the Call was a slightly risky proposition and leaves you with unlimited potential losses. You need a hedge on that open Call sold position.

You can buy the underlying security itself and set off possible potential losses on the Call with the appreciation on the underlying.

In the current Indian situation, you can buy Futures on the underlying (rather than the underlying itself) and create a similar hedge on your Call.

Can we take an example?

You have sold Reliance 280 Calls (at Rs 12) when prices got depressed on account of war related rumours. You were at that time bearish on Reliance and quite justified in selling these calls.

Now that the war rumours have died down, Reliance appears to be moving up (or you believe that Reliance might move up). Your call position is still outstanding and you could face losses if Reliance in fact moves up.

You want to protect your position. If you buy Reliance at say Rs 282 now, your position is now hedged. Any upward movement now will generate profits on your Reliance holdings which will upset any losses on the Calls.

Alternatively, you could buy Reliance Futures instead. This would reduce your requirement of funds and could be more interesting than buying the underlying shares themselves.

What are the risks of this protection?

While you have successfully covered the upward risk of Reliance shares, you have now assumed downward risk. If Reliance moves down to say Rs 250, your Reliance portfolio will generate a loss of Rs 32 while the Income from the Call was only Rs 12.

Where else can the Covered Call be useful?

uppose you are bullish on a Scrip and are hence buying the Scrip now (or the Futures on the Scrip), you can use Covered Calls to reduce your effective cost.

Can we take an Example?

Suppose Hindustan Lever is quoting at Rs 185 and you are bullish on the Scrip and hence want to buy the Scrip (or its Futures). You however do not believe that the Scrip will move up beyond Rs 200 in the next 30 days.

You could buy the Scrip (or its Futures) for Rs 185 and at the same time sell a Call on the Scrip with Strike Price Rs 200. You could earn an Income of say Rs 8 on the Call.

This would reduce your effective cost of acquisition to Rs 177 (Rs 185 less Rs 8).

What is the risk in this case?

The risk is that of Opportunity Loss. You are (by accepting a premium of Rs 8) giving up all appreciation benefits beyond Rs 200. Thus, if the Scrip touches Rs 206, you will be entitled to appreciation only up to Rs 200. The gains beyond this level will be offset against losses on the Call.

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