Today, the equity market has been discounted by almost 50% from its peak. Investors are bearish to enter in this market. In the current scenario Indian equity markets are reacting with global cues. So, any positive cue of stabilization in global markets will start showing uptrend in our markets too. To take the advantage of this uptrend with minimum risk exposure in these scenario investors should follow the 90/10 strategy which will keep them in the loop. Now, there might be few questions rising in the mind of investors such as, what is 90/10 strategy? How they will be benefiting with this strategy?
Basically, the 90/10 strategy involves purchasing calls on the same number of shares of stock that would have been purchased outright, then investing the difference in a fixed income security such as government bonds. The name of the strategy is derived from the most common proportion in which the investments are allocated: 90 percent in government bonds and 10 percent in index or stock call options. This strategy is particularly appropriate for an investor who is not interested to risk his/her capital by investing in the stock market but wishes to participate in the growth of the stock market with limited risk exposure. Interest on the government bonds covers part of the possible loss on the calls. This strategy permits the investor to benefit from favorable stock price movements while limiting the downside risk to the call premium less any interest earned. It is particularly effective approach in periods of high interest rates because of greater interest income.

Example:
The common stock of ABC sells at Rs. 2000 per share. The purchase of 100 shares will cost Rs. 200,000. Let’s also assume that this investor’s upper limit on investment is Rs. 200,000.
Now, let’s assume that the stock call option’s strike price is fixed at Rs. 2000 per share, with a premium of Rs 200 per share. Therefore, if the investor wants to buy the hundred shares it would cost him/her just Rs. 20000. This, in turn, would leave him/her Rs. 180,000 to be invested in something safer, such as government bonds.
Suppose the government bonds mature in six months and earn 6 percent interest. The Rs. 180,000 would earn interest of Rs. 5400 (Rs. 1,80,000 x 0.06 x 6/12). This interest reduces the investor’s cost of the call to Rs. 14600 (Rs. 20000 - Rs. 5400). The Rs. 14600 also represents the investors maximum risk exposure compared to the Rs. 200,000 cost if the 100 shares were purchased outright.
The beauty of this strategy is that although the risk is limited, the potential capital appreciation is not. Once the market price of ABC increases beyond the strike price, the call buyer could realize the same rupee appreciation at expiration as that of an investor who owns 100 shares of the common stock. Therefore, this strategy limits risk to the net cost of the call while still enabling investors to realize capital appreciation.

A covered call is an option strategy in which an investor buys an asset (long position in a stock) from the cash market and writes (sells or takes a short position) call options in the derivatives segment on the same asset. The potential obligation to deliver the stock is covered by the underlying stock in the portfolio; hence it is called a “covered” position. It is also called a “buy-write.” A buyer of a call option has the right, but not an obligation to buy the underlying asset. If one buys (i.e. goes long) a call option one is bullish on the asset, means he/she expecting the market to rise. In case one writes (sells or goes short) a call option, he/she is bearish on the asset, expecting the market to fall.

Let’s understand with an example how a covered call works.
ABC Ltd. shares are being traded at Rs. 38 (cash market price/spot price) and the June 40 call (strike price/exercise price) is being sold at a premium of Rs. 3. As one writes a call option, one receives the premium of Rs. 3. The maximum profit one can receive in this exercise is Rs. 5 i.e. the difference between the prices and the premium one receives writing the call. Now, if the spot price is, say, Rs. 42, the option will not be exercised, and what one receives is the premium amount only. Unlimited risk is not possible as one owes the underlying stock. One needs to buy minimum shares in the cash market equal to the lot size of that particular call option.

One of three situations can occur:

• If the shares trade below the strike price, i.e. Rs.40, the option will expire worthless and what one receives is the premium from the option. In this case, one has outperformed the stock.
• If the share prices fall, the option expires worthless and what one gains is the premium; again one has outperformed the stock.
• If the share prices rise beyond Rs.40, the option is exercised. One loses in the option market, but gains in the cash market.

In options we have two values i.e. Intrinsic Value and the Time Value. If the stock is traded at Rs. 42, the June 40 call will have an intrinsic value of Rs. 2. If the calls are traded at Rs. 5 premium then the difference, i.e. Rs. 3, is the time value for the June 40 call.

The advantages of covered calls are that one can reduce the average cost of a stock in the portfolio and can generate income from the option premium. It is a strategy preferred by risk-averse investors. Normally, investors do it when they plan to sell a stock at a predetermined price. In such cases, the call written by them imposes self-discipline as it ensures that the stock is sold as a planned strategy. They enjoy the premium from the call options and the dividends till the time they hold the stock. The disadvantages are limited profits and the potential gains from the increase in the stock price (cash market) above the exercise prices are foregone. While using this strategy the trading costs should be taken in to account. A covered call strategy can be best used when one does not expect much movement in the stock price.

The author is a Research Analyst working at Apnaloan.com Services (P) Limited