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Earning without extra risk

Earning without extra risk

The covered call strategy can help enhance the investor’s returns without increasing the threat to the portfolio.

In our previous issue, we had explained the benefits of buying a call option when you are anticipating bullishness in the near term. The investor gains if the index or the stock—which he doesn’t hold—rises beyond the strike price. However, if one holds shares in a company and the share price is not expected to move considerably in the near term, a covered call strategy proves useful. It generates income for the investor and enhances the returns over his defined exit price. This strategy has a limited profit potential and suits the investors who intend to sell the stock within a month.

The modus operandi is simple enough: the investor takes a short position on a call option (or writes a call option) of the stock he owns. By doing so, he promises to sell the number of shares in a contract to the buyer at the defined strike price in case the option is exercised. However, his short position is covered by the fact that he is holding the underlying stock. Hence, the strategy is termed covered call.

The profit potential of the strategy is the premium paid by the buyer of the option plus the difference between the buying price of the stocks and the preset exit price. The strike price of the call option is crucial. It should ideally be an OTM option, where the strike price is higher than the market price of the underlying stock. This is because the buyer will not exercise the option unless the market price is above the strike price. The seller pockets the premium on the call, which effectively reduces the cost of his stock holding. Consider that the investor bought the shares for Rs 75 each. The Rs 5 premium he receives from the option buyer will reduce his purchase price to Rs 70.

In addition to the premium received, the seller is entitled to dividends (if they have been declared) on the stock he owns unless the option is exercised. The break-even point is reached when the stock price falls and the drop is equal to the premium received.

The strategy is suitable if the investor has decided to exit the stock at a certain price and does not expect any extraordinary event to affect the market price in the short term. What needs to be stressed here is that he has already set the profit limit on the stock.

THE RISKS: Although the strategy is relatively safe, there is some risk involved. The seller is obliged to sell the stock at the strike price if the call is exercised. In India, option trades are settled in cash. On exercising the option, the seller has to pay cash on the basis of the closing stock price. One needs to closely monitor the stock price movement. If the stock price shoots up considerably beyond the strike price, the buyer may exercise the call option. If the investor is unable to sell the stock on that day and it falls, he may suffer a loss.

The other risk is if the stock price falls below the purchase price. While the premium received from the option buyer will cushion the loss to a certain extent, it won’t be of much help if the fall is substantial. However, this will only be a notional loss if the investor decides not to sell at the lower price.

Let us consider an example to understand how a covered call strategy works. Mr A holds 300 shares in XYZ Ltd. He had purchased the shares at Rs 75 per share. The current market price is Rs 80 per share. Mr A wants to earn income on his stocks and doesn’t mind exiting at Rs 85. The call option on XYZ for a strike price of Rs 85 is available at Rs 5. The market lot of XYZ is 100 shares.

Mr A sells (or writes) three OTM call option contracts with a strike price of Rs 85 per share. He will receive Rs 1,500 as premium (see table) from the buyer of the call options. This premium is additional income because Mr A keeps it regardless of the call being exercised or not. If the stock exceeds the strike price and the call is exercised, Mr A will be required to pay the difference to the buyer. At the same time, he will sell the shares and use the proceeds to pay the buyer.

As the options are settled in cash, let us understand the payoffs in case the option is exercised when the share price is Rs 100. Mr A will sell the shares for Rs 30,000. Of this, Rs 4,500 will be paid to the buyer as the difference between the market price and the strike price. After including the premium of Rs 1,500, the total net proceeds are Rs 27,000. The effective return earned is 20%, which is above the target return of 13.33%.

If the stock price falls below Rs 70, the strategy will result in a loss, which is an unrealised loss unless the stock is sold. The break-even point (no loss/no gain) of covered call strategy is reached at the price of Rs 70 per share, which is the difference between the purchase price and the premium.

Published on: Nov 04, 2009, 9:18 PM IST
Posted by: AtMigration, Nov 04, 2009, 9:18 PM IST