Here's how to use covered calls to reduce cost of holding a stock

But, what exactly is a Covered Call strategy?

A 'covered call' is a simple hybrid strategy of selling higher Call options. When you buy a Call you get a right to buy without the obligation. But, when you sell a Call you get the obligation to sell the stock without the right.

Let us now get back to our illustration on Tata Steel. Paresh had bought Tata Steel at a price of Rs 530. Currently, the stock is quoting at let’s say Rs 502.

While it is a notional loss, his funds have been locked up in Tata Steel for the last six months. That is where a covered call would have helped.

In a covered call, the investor holds on to the cash position in Tata Steel but keeps selling higher strike Call options. This is how a covered call strategy will look like when the spot price is Rs 502.

Cash Market Trade Call Option Trade:

Buy Tata Steel (1,061 shares) at Rs 530

Sell 1 Lot 530 Strike Call at Rs 9.50

Now there are three possible price outcomes in the above case:

• If the stock price remains below Rs 530, then the entire option premium of Rs 9.50 will come into Paresh’s account and reduce his cost of Tata Steel to Rs 520.50.

• If the stock price goes sharply lower, then Paresh still earns the premium of Rs 9.50 but the notional loss on Tata Steel widens. That is not a comfortable situation.

• If the stock price goes up to Rs 560, then there is a loss on the short call but since he is long on the cash market position, he has nothing much to really worry about.

Using covered call to consistently reduce your cost of holding the stock. In fact, this is where the real power of a Covered Call is realised.

If the view is that Tata Steel will not breach above the Rs 530 mark then each month Paresh can earn the premium by selling the higher Call. Since the option expires on the last Thursday of the month, each month he will have to write a fresh short call.

Does that mean each month he will make a profit on the call? Not exactly! In some months the price movement may not favour and Paresh will have to book a loss.

Let us look at a practical scenario of how this strategy will work over a period of six months where some months are good and some are bad.

The table below captures how the Covered call would have panned out in the last 6 months:

By consistently selling higher calls for six months, Paresh would have made Rs 17.25 as net profit on selling calls. That effectively reduces his cost of holding Tata Steel from Rs 530 to Rs 512.75.

At the current market price of Rs 502, your MTM loss now looks a lot more justifiable. That is the advantage that you get from a covered call strategy.

Two very important precautions needed in a covered call:

While a covered call is a great strategy to reduce your cost and put your investment to work, there are two important things that you need to keep in mind.

a) Some traders buy futures on the stock instead of a cash market position. The risk is that if the stock price falls sharply then your call has limited profit but your MTM losses on the futures can mount.

b) At no point should this strategy be closed as a single leg. For example, if the price goes up, don’t book profits on the cash market position and hold the short call. You are not hedged and your losses can mount rapidly.

Covered calls are simple to use and easy to understand. In a volatile market like India, these covered calls can be a good bet; at least on predictable stocks with inherent strengths.

The author is Chief Analyst – Technical & Derivatives - Angel Broking.

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