When you buy an option you pay the premium.Therefore, you have limited downsides to the extent of the premiums paid but unlimited profits if the price of the underlying moves in your favour. This applies in the case of call options and put options. On the other hand, when you sell options, your earnings are limited to the extent of the premium earned but your losses can be potentially unlimited. Prima facie, it looks like the selling of options could be much more risky. But in reality it is not the case because most option sellers do not sell naked options. On the other hand, they use selling options as a means to cover their risk. To understand this concept,let us first understand the concept of a covered a call.
What is the concept of a Covered Call?
One of the popular ways of using options is through the implementation of hybrid strategies. In hybrids you either combine the options position with another option or with a cash or futures position.This way, you are able to define your risk and return parameters in a more granular fashion. One such popular strategy is called the covered call option.So, how exactly does it work?
In a covered call, an investor who is holding onto a long position in the stock or in the futures sells a higher call option.The expectation in this case is that the stock is unlikely to rise too sharply and so the Out-of-the-Money (OTM) call will expire worthless. When the option expires worthless the investor earns the entire premium and by consistently doing so he is able to reduce the cost of holding on the equity or futures position. Let us delve a little deeper with a live example of a stock.
Using covered call in SBI to reduce cost of holding..
The stock of SBI has failed to breach the level of Rs.315 over the past 1 year despite repeated attempts. With the pressure of NPAs building up, Rajesh Shah believes that SBI is unlikely to breach this level on the upside in the next 1 year. But, Rajesh has a practical problem. He had purchased 3000 shares of SBI last month at Rs.290. The stock is currently quoting at Rs.280 and Rajesh is willing to hold on to the stock for the next 1year. He is quite confident that over the next 1 year favourable government policy will enable the stock to cross the 320 levels. So what best can he do inthe next 6 months with his SBI holdings? Since he is not expecting the stock to go above its peak level of Rs.315, he can structure a covered call on SBI. At the beginning of each month he will sell the 310 Call of SBI with the hope that the option will expire and he will be able to earn the entire premium.
The table below captures how the Covered call will pan out in the next 6 months..
Spot price of SBI
Call Option Sold
As the table suggests, Rajesh has been selling310 strike call options at the beginning of each month. Depending on the price movement he has either let the option expire worthless or has squared off 310strike call option sold. Out of the 6 months during which he sold the options,these options expired worthless in 3 months. During two of the months he had to cover his short option position by buying it back at a smaller profit. In the first month he booked a small loss due to the volatility in the stock.
Rajesh ends the 6 month period with a net profitof Rs.12.95 by selling the options. For the sake of simplicity we have avoided imputing the brokerage and STT on options, but that is unlikely to substantially change the equation. That means his cost of acquisition for SBI has actually come down to Rs.277.05 (290-12.95). So, instead of idly sitting on the stock, Rajesh has reduced his cost of acquisition of SBI from Rs.290 to Rs.277.05 in the intervening 6 months. This will also enhance the profit and ROI for Rajesh.
Let us look at 2 extreme scenarios..
If there is a very sharp fall in the price of SBI, then the equation may not really work in favour of Rajesh. The entire equation works only because there is the assumption that the stock price of SBI will not crack too sharply. If the stock falls below Rs.250, then his MTM loss on the cash market position will be too high and the option selling will not be able to compensate for that.
On the other hand, what happens if the stock of SBI shoots up to Rs.330. Of course, you will start losing money on your options beyond Rs.310, but you have nothing to worry as you are still holding on to your cash market position. It is very important to remember that you must not book profits on your cash market position and leave your short call option naked. Then losses can be unlimited and defeats the entire purpose of the covered call.