In this covered call guide, we will take a look at how, when and why covered call strategy should be used.
What are Covered Calls?
Covered call is selling/writing a call option on a stock/underlying while holding the underlying in adequate quantity. Adequate quantity here means that if you sell 1 lot of the stock/underlying you have purchased a minimum of 1 lot of the stock/quantity.
If your quantity purchased is 10 and you sell/write a call where the lot size is 100 then it is not a covered call.
Caution if you are not sure about the number of shares in a lot, please download the lot size CSV file from, NSE website, and check.
Is a covered call strategy useful?
Covered call writing is a great strategy to employ on a portfolio for generating a cash flow while stocks are held. Covered calls guide takes you through the terminology, profit and loss potential.
At the end there is a covered call spreadsheet to help you decide whether covered calls are possible and profitable for your portfolio.
What are options in financial markets?
Options are a derivative instrument, based on an underlying, which gives the option buyer a choice and the seller an obligation.
This choice is of two types:
- Call Option – Right to buy
- Put Option – Right to Sell
In this article we will cover the obligation of a seller in Call option who has the underlying stock.
What is an underlying in call options?
An underlying is the stock (or index) whose price is the basis for the settlement of the call option.Think of the stock price as the event and call option as the prediction of the magnitude of the event.
Covered calls are the selling of right to buy while owning the underlying.
Selling a call option on a stock owned by you is called a covered call. The stock quantity owned must be equal to a lot minimum.
Why use covered calls?
Covered calls help an investor generate cash from stocks he intends to hold.
I didn’t add the word “long-term” to the end of the above sentence, may be I forgot?
No, the reason I am notadding “long-term” is that it contradicts the basic principle of a covered call. Covered calls are used to avoid getting married to a stock, that is be able to sell their stock(s) at a profit/minimum loss.
Savvy investors believe in returns. Short-term or long-term is a matter of chance. You should always investin companies that you would hold even if prices fall. Investing is the alchemy of patience, knowledge and realization of profits when available.
Pre-requisites
- Capital
- Margin required: Cash and Pledge stock(charges of various brokers.)
- Time: 4 minutes
Explanation of pre-requisites
Capital
A covered call can only be done if you own the underlying asset in minimum 1 lot quantity. A “lot” is the term used for minimum quantity of the underlysing asset which is equal to 1 Call option.
Let us take a look at Reliance covered call to see the capital required:
Lot: 505 shares
(This can change, NSE website check.)
Market Price: 2,000 (22-07-2020)
Capital required to purchase the underlying: 505 x 2,000 = 10,10,000
Selling Calls requires Margin: 2,76,428
(can differ by broker, Zerodha Margin Calculator, Open Account at Zerodha)
Before you decide to do a covered call please make sure you have adequate capital to purchase the required shares and to write the call.
Margin Required for covered calls:
After you have purchased the shares, you need to have adequate margin to sell the call.
As mentioned above to sell the Reliance call the margin required is: 2,76,428.
You can get half the margin required for overnight options position by pledging the shares. Read this excellent post about pledging and charges applicable on it by Zerodha.
We use Zerodha, Open Account at Zerodha.
If we don’t have half the required margin in cash in the trading account, there is a delayed payment(interest) charge deducted from your account per day.
Time: 4 minutes
If you understand the concept of covered calls, this is minimum time needed to execute a covered call.Two minutes to decide the strike price and place the order, Two minutes at the time of expiry to see where the stock price is and place orders.
Need to understand the basic concept of covered calls? Click here
Orders to be placed for a covered call
- Buy x number of shares of XYZ company. (This might not be required if you already have the shares)
- Sell Call of XYZ Strike Price and price you want to sell at.
On expiry.
If price is above the Strike Price you sold at:
- Sell x number of shares of XYZ at Current Market Price.
- Buy Call of XYZ same strike as sold at price.
(Note: In illiquid stock options it is sometimes not possible to buy the call at a reasonable price. I would suggest selling your shares in the last hour of trading and letting the call expire. There is a slight risk here. Detailed Below)
When to use Covered Calls?
I would suggest using them from day 1 of your purchase till the time you hold the shares. The benefits if done on a large capital base are just too good to pass up.
When and how to purchase your dream share? Read our smart portfolio builder, click here.
i) Stock price is above your purchase price
Congratulations! you picked a stock which is giving you unrealized profit. let us try and make it into relaized.
If the price is already above your purchase price it is a good idea statistically to sell a call. Most of us face theproblem of not selling when a stock is in profit. If you sell a call and the price goes above the strike price of the call it is almost a given that you will have to sell the stock. Thus ensuring you have profits.
If stock price remains stable and below the strike price of call then you have generated some cash and still hold the stock.
If stock price goes down your covered call is giving you some cash to cushion the fall. You can decide to sell the shares and close the call.
ii) When stock is below purchase price
This seems counter-intuitive, but is a very important aspect of covered calls.
We have all been wrong about stocks. I have been more wrong that right about them.
If a stock is below our purchase price a covered call can rescue or provide a way back to us depending on how much theshare has fallen. If you have been writing calls since the purchase of shares chances are your losses are not very high. Now what you can do is sell calls and make sure you don’t hold a loosing stock.
If you think it is a great company and that the price will rise, even then sell the covered call.
No one can predict how far a shareprice might fall. Write the call and exit if you are making a loss. There are other opportunities in the market and your capital can be better utilized.
The share might rise long term, statistically it will be better for you to utilize the capital in other stocks andcovered calls because in the longer term you will have made more profits than the rise in stock prices in that one stock.
iii) When you have a lot of capital
The way to make profits is diversification and utilizing the capital to generate profits. Covered calls have a statistically edge to generate profits. Read the advantages in the next section
Benefits of Covered Calls
i) Protection against bad stock picks.
In India, for a stock to have an option chain a set of conditions has to be met this, usually, weeds out the tempting but not suited to risk appetite stocks.
I hear you in the comments saying “YES BANK” and “IDEA”. Yes, but law of large numbers will make you profits.
ii) Realizing profits
If the price of an investment goes up 5% in a month, our human tendency is to hold and hope it goes up another few percent. While it would be great for this to happen, chances are if you pick 10 stocks 2-3 will follow this and the rest will end up in negative territory. Covered calls make you realize the profit, realized profits are better than unrealized profits.
iii) Auto-Diversification
If you are doing covered calls the rule where you exit a stock if price is above the sold call strike price ensures that you build up a more diversified portfolio as shares are always being rotated.
iv) Capital Utilization
Since half the margin for writing a call needs to be in cash, you are never fully invested in the market which is a good thing. It can help you manage your funds better and capitalize on opportunities.
v) Cash flow when Stock price is stable
Since the covered call is written every month, if the stock price remains near about the same you will get the premium. While waiting for the stock to rise. Cash when the stock is stable is good for your portfolio.
When the stock finally moves up and crosses your covered call strike price, you will have made much more than the difference of purchase price and covered call strike price.
Disadvantages of Covered Calls
i) Capped Profit
If you are selling covered calls, you are taking on the obligation of selling your shares at a fixed price if, at the end of the month, price is above the covered call strike price. This means that if the stock price shoots up 50% in amonth, you won’t get the 50% return but only the difference between your purchase price and covered call strike price plus premium. Your upside is capped.
ii) Capital Intensive
As seen in the example, covered calls are capital intensive. You have to buy the full lot(minimum) of a stock, and provide margin for selling the call. Covered calls should be done on 10-20 stocks at a time for the full statistical edge that they provide. You will need a lot of capital to do covered calls with a statistical advantage.
iii) Capital loss
Covered calls can leave you “bag-holding”, i.e. you bought a stock and the price went down significantly in the first month. You took some premium but now you can’t write/sell a call above your purchase price because no one is giving you any premium. You have two choices at this point, either wait till price recovers enough for you to sell calls at a price higher than your purchase or write calls at a price lower than your purchase which can lead to a capital loss.
If you are diversified and have a large capital base this loss should not be something to worry too much about. Statistically, you will be better off writing the call at a price lower than your purchase price.
Covered Call example, Click here.
Covered Call Concept explanation, Click here.
All information here is for educational/research purposes only, we do not recommend trading.