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COVERED call is a strategy where an investor buys a stock and simultaneously writes a call option on that stock. The idea behind such strategy is that, in case the stock rises sharply after it is written, any loss from the option position will be offset by the gain in the stock. Simultaneously, since there is a premium receipt for writing the call, it lowers the break-even level for the stock position. In covered call, the selection of security and the strike price is crucial for determining the risk-return parameter to the investor.

Security on Hand: In the case of a security, if the investor already owns the security and has decided to sell it at a higher price there are two alternatives available.

* One is to place a limit order at the target price/

* * The other is to selling a call option at the target price, thereby increasing the overall return.

For example, an investor owning Infosys shares now may decide to sell it once the share price goes to Rs 3,500. Instead of entering a limit order at this price, selling a call with a strike price of Rs 3,500 will increase the overall return, as the investor will receive premium for writing such calls. On the other hand, an option with a lower strike price can be chosen such that the effective realisation along with the premium leads to the target price. Since a lower strike price has a higher probability of being called, it increases the chance of the sale than a normal limit order. For example, if the call with a strike price of Rs 3,400 is written say for a premium of Rs 45 per share, though the effective price realisation will be Rs 3,445, it increases the chance of the share being sold rather than a limit order with a limit price of Rs 3,445.

Without the Security: In case the investor does not own the security but enters into both sides of the transaction mainly as a method to earn the premium, stocks with less volatility will be preferred to stocks with higher volatility. Highly volatile scrips increase the chance that the written call will be either called (when the stock price goes up) or the investor ends with real loss (when the stock price comes down). Hence low beta stocks or stocks with lower volatility will fill the need.

Strike Price: Another important variable in covered call is the strike price. What should it be? Is the investor better off with a strike price close to the current market price (at-the money) or should he settle for a strike price, which is either in-the money, or out of the money? Many investors buy the stock and write a covered call with a strike price, which is either close to the market price or above the current market price. For example, an investor may buy Infosys shares at a price of Rs 3,050 and write a call option with a strike price of Rs 3,100. Since this is an out-of- money option, maximum returns to the investor will accrue when the share price goes above this strike price.

In-the-money call: An alternate method is to write call options which are in the money. In this case, the investor will be buying the security and writing calls with a strike price lower than the current market price.

You may wonder why an investor should buy the stock in the cash market at Rs 3,050 and give away the option to someone else to buy the same stock at a lower price by writing this option? The answer lies in capturing the time value of the option with certainty. What makes this strategy of ITM covered call is that in most cases, you will be receiving a high rate of return and also getting a big downside protection.

(to be continued)

If you have any queries relating to the futures / options marketsa 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 e-mail them to vaidy@thehindu.co.in with a mention of futures/options in the subject line of the mail.

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