Here#39;s how to use covered calls to reduce cost of holding a stock
When Paresh Shah bought shares of Tata Steel, he had done so with a lot of conviction that the stock would eventually move up. However, after six months, he found that despite all the pep talk from his broker and the rosy picture painted by analysts, the stock was still trading below his purchase price.
What is more concerning is the fact that the stock was not even showing signs of momentum. What can Paresh do at this point in time? Frankly, that is not too complicated.
Tata Steel represents a solid business from a reputed business group and has rewarded investors in the past. Paresh himself is convinced that the stock is a good investment and is willing to wait.
But, waiting has a cost and that cost is in the form of lost opportunities. Can Paresh make his investment productive in such a way that he at least earns some money even as he holds the stock of Tata Steel? The answer could be a ‘Covered Call’.
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.
Disclaimer: The views and investment tips expressed by investment expert on Moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.