Covered Call – An Option Strategy
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