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We have discussed covered call strategy previously in this column. Our argument has been that covered call should not be viewed as an income strategy. In one of our discussions, we compared covered call to bull call spread to show the similarity between the two strategies. Truth be told, covered call is considered by many as an income strategy. This week, we discuss a scenario where covered call can be positioned as an income strategy.
Loss aversion
You bought a stock, hoping to take profits soon. The stock has since declined but you do not want to sell the stock till it bounces back to your purchase price. This behavioural attitude is not uncommon. All of us dislike taking losses. The best way to avoid taking losses is to postpone the decision to sell. This is because realised losses are painful whereas unrealised losses are not, as you can recover your losses if the stock bounces back later. That is why many traders avoid closing their loss-making position. This behavioural attitude is referred to as loss aversion.
What can you do with a stock carrying unrealised losses in your trading portfolio? If you are an experienced trader (who still suffers from loss aversion), you have a suite of salvage strategies to recover unrealised losses. One such strategy that any trader can use is covered call. To recap, a covered call is shorting a higher strike call against an existing stock position.
The maximum profit from your short call is the premium received when you initiate the trade. Therefore, the downside on the stock is protected only to the extent of the premium received. But that should not be relevant for the trade. Why? You were intending to hold the stock till it reaches your purchase price. And that means you were willing to take more unrealised losses just to breakeven on your original trade.
You must choose an appropriate strike call to short. If the stock is currently trading lower but within 10 per cent of your purchase price, you can short the strike that is equal to your purchase price. What if the stock is currently trading at a price that is lower than 10 per cent of your purchase price? Then, look for a strong resistance level closer to the current stock price and short one strike above that resistance level.
Optional reading
Given your objective of breaking even on the stock position, the risk of the stock getting called away is not an issue. You can, therefore, choose the near-month or the next-month contract. While next-month contracts will allow you to receive larger premiums, low liquidity could mean that the contracts may not be reasonably priced; they will likely have lower implied volatility compared to near-month contracts. Note that the strategy will work only if you hold shares in quantities that are equal to or in multiples of the permitted lot size for an option.
The author offers training programmes for individuals to manage their personal investments
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