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Sunday, Dec 21, 2003

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Using futures/options

C. Raja Rajeshwari

Could you explain in-the-money covered calls? - Sue Kostick

If you are an investor who wants to earn more but do not want to be exposed to too much downside risk in the covered call strategy, then choosing an in-the-money call would help. An in-the-money covered call reduces your downside risk as compared to an out-of-the-money covered call.

It is used more for return generating purpose than as a risk reduction strategy.

You have to choose between an in-the-money covered call and an out-of-the-money covered call, based on your risk-return profile.

In general, a covered call is initiated to earn more from a position the investor already holds.

If you are an investor who is going to hold the underlying position for a long period; then the temporary fall in the spot price should not be of much importance to you.

Why does this in-the-money covered call carry less risk as compared with an out-of-the-money covered call?

The in-the-money offers you a lower break-even point than the out-of-the-money call.

A break-even point for the covered call is the difference between the price at which you picked up the position in the stock and the premium received on the short position in the call.

For instance, if you have bought the underlying stock at Rs 520; the out-of-the-money call Rs 530 costs Rs 3 and the in-the-money Rs 510 costs Rs 14.

The break-even point for the in-the-money call would be at Rs 506 (Rs 520-Rs 14), which means that you have a profit if the stock price is above Rs 506. Any declines below Rs 506 would mean losses.

# The break-even point of the in-the-money covered call - Rs 506 is lower than the out-of-the money covered call's break-even point of Rs 517. Hence, an in-the-money covered call allows more room for the underlying stock to decline, before the position makes loss.

Why does the out-of-the money covered call provide you with more returns than an in-the-money covered call?

The out-of-the-money offers you more returns because; the maximum profit is the premium received plus the difference between the call strike and the price at which you purchased the stock.

So you would see that the maximum profit you make from the out-of-the money covered call is Rs 13 (3 + 530 - 520).

In an in-the-money covered call, the maximum profit would be Rs 4 (14 + 510-520). An in-the-money covered call is written with an intention of being called upon.

Because, on assignment, the call writer pays only the intrinsic value of the call.

# The intrinsic value of the call is the difference between the spot and the strike price.

# The time value of the call is the difference between the price and the intrinsic value of the call.

Hence, the time value component is the profit you make. At the time of initiation, if the in-the-money is trading at its intrinsic value then it does not make sense to write such a call. On the other hand, with the out-of-the-money covered call, it is better to square off the position by selling it off in the open market before it turns in-the-money.

When to use: In terms of the risk-return profile, an in-the-money covered call is less aggressive as compared with an out-of-the-money covered call. The in-the-money covered call is used when the outlook for the underlying is slightly bearish to neutral; this strategy provides you with high leeway for the stock to decline.

The out-of-the-money is used when the underlying stock has a slightly bullish to neutral outlook.

If you have any queries relating to the futures/options markets and strategies that can be used in these markets, please mail them to Futures & Options, Kasturi & sons, 859-860, Anna Salai, Chennai 600 002 or email them to

fno@thehindu.co.in with a mention of futures/options in the subject line of the mail.

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