Derivatives

Is covered call an income strategy?

Venkatesh Bangaruswamy | Updated on October 09, 2021

If objective is to earn premium by shorting calls, you should expect the stock to move sideways or marginally down

This week, we revisit covered call strategy that we discussed earlier this year. Previously, we discussed how to set up this strategy. In this article, we discuss why you should be wary of considering covered call as an income strategy.

Strategic bets

Covered call strategy typically involves shorting out-of-the-money (OTM) near-month calls on an asset that you already hold in your portfolio. The objective is to earn premium from the short calls. Hence, the reference to income strategy. But this seems to suggest that you can earn steady stream of income by simply shorting OTM calls against a long stock. That may not be true. Consider the following:

First, if your objective is to earn premium by shorting calls, you should expect the stock to move sideways or marginally down. Then, shorting an at-the-money (ATM) call would be more profitable. In a covered call, you short an OTM call. This means you have a moderately bullish view on the stock. In that sense, it is comparable to bull call spread, where you are long a lower strike call and short a higher strike call.

Second, calling this an income strategy would be meaningful if you decide to hold the stock in your portfolio without regard to its upside potential or downside risk. But that requires some active management of the stock in your portfolio. Suppose the stock moves beyond the strike price, you shares will be called away for delivery at expiry of the option contract. This means you must buy back the shares from the spot market later at a price that is closer to the strike price of the short call. Any price higher than the strike price will cut into the profits on your covered call.

Third, this strategy is a bet on implied volatility (IV). The premium you collect on the short call is your maximum profit if the option expires worthless. But if you want to close your position any time before expiry, it is the decline in implied volatility that will accelerate the time decay of the option.

Fourth, this strategy could be useful during range bound markets. By shorting an OTM call, you cap the upside on the stock. Suppose you hold 1375 shares (one permitted lot size for options) of ICICI Bank in your demat account. Suppose you short October 740 calls for 8.5 points based on your view that ICICI Bank is unlikely to move past 737. If the stock breaks above 740, you may be asked to deliver the stock against the short call, capping the upside.

The above discussion suggests that covered call is not simply about collecting premiums by shorting an OTM call against an already-held stock position. Rather, it is a strategic bet on the direction of the underlying with a view on the implied volatility of OTM calls. It also requires active management of the underlying in the event the stock gets called away.

Optional reading

Stocks you plan to hold for a long term regardless of its price movement in the short term are ideal candidates for covered call strategy. Returns ought to be based on cash yield (premium earned divided by the cost of the stock) if you consider this as a pure income strategy. For ICICI Bank, that would be 1.45 per cent (8.5 divided by assumed cost of 580). Note that annualizing the returns could be misleading, as it assumes you can earn the same return every month through the year.

Your maximum returns would be 29 per cent if the option is exercised. This is calculated as follows: maximum profit (168.50 if exercised) divided by the cost of the stock (580). Your maximum profit is calculated as 740 (strike) minus 580 (cost) plus 8.5 points call premium. Your actual profits would depend on the stock price at the time of option expiry.

The author offers training programmes for individuals to manage their personal investments

Published on October 09, 2021

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