22-08-2012, 10:03 AM
The Covered Call
covered call.ppt (Size: 301 KB / Downloads: 29)
Definition of 'Covered Call'
An options strategy whereby an investor holds a long position in an asset and writes (sells) call options on that same asset in an attempt to generate increased income from the asset.
This is often employed when an investor has a short-term neutral view on the asset and for this reason hold the asset long and simultaneously have a short position via the option to generate income from the option premium.
Strategy :The covered call is a strategy in which an investor writes a call option contract while at the same time owning an equivalent number of shares of the underlying stock.
Market Opinion : Neutral to Bullish on the Underlying Stock
When to Use : The investor desires to either generate additional income from shares of the underlying stock, and/or provide a limited amount of protection against a decline in underlying stock value.
Why covered call makes sense in India
The number of ways the covered call seller benefits :
If the option volatility reduces, he makes the difference of the volatility premium
As the time to expiry reduces , he makes money on the time value
If at expiry the price is below the strike price , he makes the entire premium , no questions asked
Disadvantages for the call buyer :
The poor fellow thinks he is minimizing his risk because he has paid a fixed amount and that is all he is risking.
Actually , though , he makes money only if the price of the stock rises, trends up , strongly. Experience shows that the market and the stocks trend only 25-30 % of the time.
So who makes the money most of the time ? Clearly , the option writer does.World wide data suggest that only 15% of the options are actually exercised
The reason for this is simple ; markets don’t trend most of the time
It is only during these relatively rare trending periods that option buyer makes money, the rest of time when markets consolidate or turn sideways , it is the option writer who makes killing- or , you can say ,he gets rent from his building.
Example
Suppose one had bought ACC stock at Rs 215, sold a call 220 Call for Rs 15 in December of 2003.
In the above case, the covered call performs better than just holding a long stock at all points other than above Rs 235.
We therefore make money if the ACC stock trades above the Rs 200 mark. That is because if the prevailing stock price is 215 , you get Rs 15 up front and your breakeven is Rs 200
ACC Closes Below Rs 220
If the stock closes below Rs 220 at the end of the month say at Rs 210, you pocket the entire Rs premium. In fact , we are fine so long as the stock does not close below Rs 200, because we have a Rs 15 hedge against a fall.
The problems starts if the stock starts to decline below Rs 200 . This can be avoided by
Using technical analysis
Writing a deeper in-the money call ( more premium)
ACC Closes above Rs 220
If it closes above Rs 220 you make Rs 5 in the stock appreciation and Rs 15 in option premium , so your effective return for the month is about 10%.
If , however , the stock closes at Rs 230 at the end of the month, you get Rs 15 as stock appreciation but since the call you have written would be exercised against you, you end up keeping only Rs 5 out of that and paying out Rs 10 .
Above Rs 220, your return remains constant at Rs 20 ( Rs 5 + Rs 15(premium) and you get no further appreciation.
ACC Closes at Rs 220
This is the ideal situation in terms of getting the best of both the worlds and it does happen with a stock such as ACC.
It allows you another month of writing at the money call options at Rs 220.