The Hindu Business Line : Covered calls

That, however, is not entirely correct for even long-term investors can use a few derivatives tricks to improve their return on investments. Using covered calls is one such way you can boost your equity returns.

How to set it?

This strategy involves selling ‘out of the money’ call options in a stock, against the purchase of an equivalent number of shares of that stock. Covered calls can also be written if you already hold an equivalent position in the underlying.

Since the strategy is almost always backed by equity holding, it is considered less risky.

When to use it?

Covered calls can be used when you are bullish on the underlying stock over the long-term but feel that the stock price will trade in a tight range over the lifetime of the contract.

Investors sitting on idle long-term holdings, looking to exit it in the near-term can also consider this strategy.

To better understand how this strategy can be used and what its limitations are, let us suppose you are bullish on the long-term prospects of TCS (trading at Rs 845).

But over the near-term, you feel that the share price would trade sideways, weighed down by the waning appetite for IT stocks in the market.

Depending on what you foresee as the upper trading range of the stock (say, Rs 900), you can consider selling calls at that strike price.

So, if you have bought, say 500 stocks of TCS at Rs 850 each, you will need to sell two lots of TCS August month

Call option at strike price Rs 900 (trading at Rs 23 per share) to cover the purchase completely.

This is so because TCS stock options have a lot size of 250 shares.

Alternately, you can also chose to partly cover your equity purchase by selling just one lot of TCS call options.

The profitability of your strategy would depend on the share price movement of TCS.

If TCS trades flat and ends the month at about the same price at which you purchased the stocks, then your sold call option will expire worthless.

This means, you will get to pocket the premium (Rs 23 per share).

But, if the stock price falls from your purchase price, while you would still get to pocket the premium, you may have to bear some notional loss on your equity investment, as its value would have also gone down by as much.

However, you can take heart from the fact that the premium pocketed from selling the options would bring down your net cost of purchase of the stock.

So, in both these cases, where the stock price fails to trend upwards you would have, in essence, outperformed the stock returns in the cash market, courtesy premium received on selling the calls.

However, if the stock price of TCS were to rise beyond Rs 900, then you may be required to part with your shares, since your sold call option would then stand the risk of being exercised.

In such a case, your upside would be capped at Rs 900, regardless of the extent of gains in the underlying’s share price.

Caveats

Since the strategy involves selling call options on a stock, note that it would limit the near-term upside potential of your stock.

So, even if the stock’s price zooms significantly above your purchase price, your returns would be limited to the difference between its purchase price in the cash market and the strike price of the sold option.

Further, writing covered calls may not be possible for all the stocks, even if they are traded in the derivatives segment, as not all stock options enjoy adequate liquidity.

This means, that you may also stand the risk of not finding any takers for your calls.

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