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Covered Call Option with Stocks

Recently we discussed married put where you can buy puts if you feared that the stock you own may drop in the price in near future. If it does, you recover some of the losses from the profits gained from the puts.

What happens if your feelings are exactly the opposite? What if you feel if the stock you own may stay at the same level, be range bound, or may rise just a few percentage? Lets take an example. You hold 500 HDFC bank shares and your view is that for sometime (say a month) the stock is going to stay more or less where it is, or may be go up a little bit but not too much, or may head south but not too much. What do you do in such a situation? How do you make money?

Covered call is the answer. What is a covered call?

Covered call can be done when you feel the stock will not move much anywhere in the next 30 days. You should own the stock in cash equivalent to its F&O lot size. Yes a no movement in stock can also bring some money into your pockets. πŸ™‚ Supposing you bought a stock at 16 and you feel it may be around the same place next few days – you can then just go and sell the 21 out of the money (OTM) call. If stock stays at the same place, or moves up, or goes a bit down you still make money. Please note that when you sell a call you receive cash. This means your cost of buying the stock goes down. So now you have a new break even which is below 16. After selling the call if the stock is anywhere above this new break-even on the expiry day you are in profit, else loss. Note that your loss is less than those traders who had the stock but did not sell the call.

Look at the image below to understand covered calls better:

covered call with stock

Side Note: This happens in most months. If you study stock markets you will see that most stocks trade in a range for months. Huge movements like 10-20% come only in a couple of months in a year. Most of the times your stock will be 5%+/- in a 30 day range. So this strategy is great to make money in those 8-10 months when the stocks does nothing. In fact even if it moves up or goes down a bit, you will make money with covered calls.

Covered Call in Details

Selling covered calls is not selling naked options, they are covered by your stocks – so the chances of loss is very less. Interesting? Lets discuss more. Lets take another example.

Lets assume you bought 500 HDFC Bank shares at Rs. 650 a share (today’s closing rate). Today is 18th of September, 2013. Your view is that for the next one month or so, its going to remain almost at the same place, or go slightly up or down. You think that it may not cross 700. Using your shares as collateral you can sell October HDFC Bank 700 calls. Today at closing it was selling at 15.00.

If HDFC bank stays below 700 on the expiry day of October 2013, you pocket a cool Rs. 7,500.00 (15*500 = 7500) without actually investing anything. You still hold the same 500 shares of HDFC bank. πŸ™‚

Even if you did not invest a single rupee while selling the call option (remember you sold using your stocks as collateral), you were still risking 3,25,000 that is the cost of buying the 500 shares of HDFC Bank. 500*650 = 3,25,000.

Lets calculate the ROI (return on investment).

Once you sell one HDFC Bank 700 Oct 2013 call at 15, you will immediately receive 15*500 = Rs. 7,500.00 in your trading account. You bought 500 HDFC Bank shares at 650 = 500*650 = 3,25,000. ((7500/325000)) * 100 = 2.30%. So your return on investment is almost 2% per month (since one and half months are left for Oct expiry – we assume its less than 2.30%). If you do this month after month you can make 25% or more on your investment of 3,25,000, which is approx Rs. 81,000.00 in one year. Yes there may be a couple of months where you may not make anything. Still even something slightly less that 81,000.00 in no small amount. Do you think HDFC bank will go up 10% every month? No, so the chances are making money are very high every month.

Isn’t it great? You keep the shares and still make a good 25% of it. If you are willing to take more risk, you can sell ATM calls and you may make more than 10% per month. But the winning months will reduce.

Well there is more to it. If HDFC Bank actually moves up but not beyond 700 on the expiry day, you keep entire premium you got for selling the call, plus you can sell your shares at 7.5% profit at 700. That’s double bonanza. Not only you made money from the calls sold, but also from selling your shares. Time for smiles :).

So where is the risk in Covered calls?

All good news till now. Time for some bad news.

1. What if HDFC shoots beyond 700? You start losing money in the sold call. However you do not lose anything till 715 – because you got 15 when you sold the call, beyond that there is a loss. But wait, you will still profit from the shares you bought. So essentially there is zero loss. Only problem is that beyond 715, you do not make any money. If there is a no-holds-bar rally in the stock, you will rue your decision to sell the call.

2. What happens if HDFC Bank falls? Yes you do keep the premium, but you make a loss in the shares you are holding. Of course if they are for long term, that’s great – but if you wanted to keep the shares for short term you have to sell them at a loss but you keep the premium you got from selling the call so your losses are slightly reduced.

No other loss in covered calls.

Covered calls is a great strategy if you hold a stock in your portfolio and want to keep it for a long time. If they fall, you keep the premium, else sell both your call and the stock to make sure you do not lose any money and re-enter the stock when it falls down.

One thing to keep in mind is that you need to keep the same number of stocks of that company as its futures shares. For HDFC bank it is 500 shares. If you buy a future of HDFC bank when its at 650 you get a leverage of 650*500 = Rs. 325,000. Therefore in my example I had taken 500 shares of HDFC bank.

You may have to pay only a fraction of that amount when you buy a future or sell a call, but your real risk is 325,000 that is 500 shares of HDFC bank.

Important note: If you do this with less number of shares than the leverage you get in futures, the math will not work and you may suffer losses. If the stock keep rising beyond the sold call, you may suffer huge losses as the numbers won’t match when you sell your shares to book profit. The loss on sold call will far exceed the profits made in selling the shares.

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