Why Do Investors Use Covered Call Strategy?

Covered-Call-Option-Strategy

One of the many uses of a call option is that it can be used to create hybrid strategies. What do we understand by hybrids? In Futures and options you can combine options with futures and with stocks to create hybrid positions in such a way that you can precisely define the returns and the risk of the overall strategy. One such strategy is the covered call strategy. In a covered call strategy you are long on an equity stock and you sell a higher call option to earn the premium. Let us first understand the structure of a covered call…

How is a covered call structured?

Let us assume that you have bought 3000 shares of SBI at Rs.248. However, you are worried that the PNB fiasco could take its toll on the price of SBI too. That would also mean that upsides on the stock will be limited for now. So against your holding of 3000 shares of SBI, you sell 1 lot (3000 shares) of SBI 270 call option at Rs.2.40 in the March 2018 contract. Let us evaluate what happens in 3 different scenarios…

  • If the stock price of SBI stays around the Rs.250 level then the 270 call expires worthless. So the Rs.2.40 premium will become the income for the investor.
  • If the stock price of SBI bounces back to Rs.300, then your maximum profit will be capped at Rs.270 level of SBI. Above Rs.270, whatever you gain on the SBI stock you will lose on the SBI 270 call option. So maximum profit on covered call will be Rs.24.40 (270-248+2.40).
  • If the stock price goes down to Rs.220 then losses can be unlimited. The investor has only downside cover till Rs.245.60 (248-2.40). Below Rs.245.60 his losses will be unlimited and hence covered call is not a good strategy in highly speculative stocks.

Using covered calls to reduce cost of holding the stock…

In the above instance if SBI if it is likely to hover around the Rs.250 levels, then each month the higher calls can be written to reduce the cost of holding SBI, even as the price does not move too much. Consider the illustration below…

Stock March 2018 April 2018 May 2018 June 2018 July 2018 August 2018
SBI Bought at Rs.248 Sold 270 call at Rs.3.25 Sold 270 call at Rs 2.25 Sold 270 call at Rs.2.95 Sold 270 call at Rs.1.55 Sold 270 call at Rs.1.25 Sold 270 call at Rs.4.25
What about the 270 call? Covered at Rs.1.25 Expired worthless Covered at Rs.0.50 Expired Worthless Exited at loss at Rs.2.65 Covered at Rs.2.85
Net Profit / loss on call Rs.+2.00 Rs.+2.25 Rs.+2.45 Rs.+1.55 Rs.-1.40 Rs.+1.60
Total Profit / Loss on Calls in 6 months Rs.+8.45

 

As can be seen from the above table, the trader booked profits on the call in 5 months and booked a loss in 1 month. The net profit of Rs.8.45 over 6 months helped the investor to reduce his overall cost of holding SBI to Rs.239.55 (248-8.45). That is how covered calls can help an investor.

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When you want to enhance returns on a high dividend yield stock

There are many high dividend yield stocks in the market which give dividend yields in excess of 5% annualized. The covered call strategy can be used to enhance the yield on these high dividend yield stocks. Let us assume that SBI pays a dividend of Rs.12.50 annualized. That works out to a dividend yield of nearly 5%. In addition, if the covered call strategy is also applied then there is an enhancement to the dividend yield. The half yearly earning on the covered calls will be 3.13% (8.45/270). This can be annualized using the formula {(1+r)2} – 1 = 6.36%. Thus even while the investor is holding on to SBI he earns 11.36% annualized return due to the combination of the dividend yield and the covered call earnings. That almost makes it like a quasi debt instrument.

Graduating covered call to a collar for the perfect hedge

The big risk in covered call is that by writing a higher call option, the upside is being capped but on the downside the risk is unlimited. That problem can be resolved by converting the covered call into a collar. A collar is nothing but a covered call plus a lower put option purchased. In this case let us assume that apart from buying SBI in spot at Rs.248 and selling a 270 call at Rs.2.40, the investor has also purchased a 230 put at Rs.2.75. Let us look at the pay-off of this collar under different price levels of SBI

SBI Different

Price Levels

Profit / loss on SBI spot bought at 248 Profit / Loss on SBI 270 Call option Profit / loss on SBI 230 put Overall strategy profit / loss
200 -48 +2.40 +27.25 -18.35
210 -38 +2.40 +17.25 -18.35
220 -28 +2.40 +7.25 -18.35
230 -18 +2.40 -2.75 -18.35
240 -08 +2.40 -2.75 -8.35
250 +02 +2.40 -2.75 1.65
260 +12 +2.40 -2.75 11.65
270 +22 +2.40 -2.75 21.65
280 +32 -7.60 -2.75 21.65
290 +42 -17.60 -2.75 21.65
300 +52 -27.60 -2.75 21.65

 

In the above collar, the maximum loss is pegged at Rs.18.35 while the maximum profit is capped at Rs.21.65. A collar is a completely closed strategy and a covered call can be graduated into a collar to avoid the unlimited downside risk. The loss is capped at the point where the put option is bought while the profit is capped at the level where the call option is sold.

Just as added information; what is the significance of the maximum loss and profit levels. The net cost of the collar is Rs.0.35 (2.75-2.40). This net cost is adjusted to the gap between the spot price and the two strike prices to get the max loss and max profit levels.

  • (230 – 248 – 0.35) = Rs.-18.35 represents the maximum loss on the collar
  • (270 – 248 – 0.35) = Rs.+21.65 represents the maximum profit on the collar