Option Strategy : Covered Call

Friday, May 30, 2014

Covered Call

where an investor holds a long position in an asset and writes (sells) call options on that same asset in an attempt to generate increased income from the asset. 

This is often employed when an investor has a short-term neutral view on the asset and for this reason hold the asset long and simultaneously have a short position via the option to generate income from the option premium.

For example, let's say I own shares of the HINDALCO and like its long-term prospects as well but feel in the shorter term the stock will likely trade relatively flat, perhaps within a few Rs up and down of its current price of, say, 150. If you sell a call option on HINDALCO for 160 Rs, you earn the premium from the option sale but cap your upside. One of three scenarios is going to play out:

  • HINDALCO shares trade flat (below the 160 Rs strike price) - the option will expire worthless and you keep the premium from the option. In this case, by using the buy-write strategy you have successfully outperformed the stock.

  • HINDALCO shares fall - the option expires worthless, you keep the premium, and again you outperform the stock.

  • HINDALCO shares rise above 160 - the option is exercised, and your upside is capped at 160 RS, plus the option premium. In this case, if the stock price goes higher than 160 Rs, plus the premium, your buy-write strategy has underperformed the HINDALCO shares.
1 lot of HINDALCO has 2000 shares ( which approximately translates into 2000 X 150 =  3 lakh Rs  investment). almost all of the lot of different stocks is in the same range. Now lets see how near month price is for different strike price of HINDALCO 
Strike price     Premium 
150                  8.55
152.5               7.15
155                  6.25
157.5               5.40
160                  4.50
At strike price of 160, which is OUT-OF-THE-MONEY, call option can be relatively safely sold and premium of 4.5 Rs, which translates into  4.5 X 2000 = 9000 Rs , from an investment of 3 lakh, which translates into 3 % monthly return (36 % annual return  Quite decent return !!!!) 

A more sophisticated investor can use future in place of stocks to implement the same strategy, but the risk involved and skill requirement is quite high. 

Source : Wikipedia

This strategy is best used when the investor would like to generate income off a long position while the market is moving sideways. It allows an investor/writer to continue a buy-and-hold strategy to make money off a stock which is currently inactive in gains. 

The investor/writer must correctly guess that the stock won't make any gains within the time frame of the option; this is best done by writing an out-of-the-money option

A covered call doesn't have as much potential for reward as other types of options, thus the risk is also low.

Time Decay

The passage of time has a positive impact on this strategy, all other things being equal.  As expiration approaches, an option tends to converge very fast on its intrinsic value, which for out-of-money calls is zero.

Main point of this strategy :
  1. It has limited profit potential.
  2. It has unlimited loss potential.
  3. Once the strategy is introduced, reduction in volatility is beneficial for this strategy.

A note of caution

As long as the short call position remains open, the investor isn't free to sell the stock. It would leave the calls uncovered and expose the investor to unlimited risk by making it a naked call.


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