Call Option Concepts: Yield Enhancement Strategy by writing Covered Calls

Yield Enhancement Strategy by writing Covered Calls

 

Selling covered calls can be used as one of the yield enhancement strategies as it increases the yield and reduce the risk for the option seller (writer). This strategy is generally used when the call writer (seller) predicts the stock to be fairly stable or rise modestly.

When an option writer sells a call option, the call option buyer (holder) gets the right but not the obligation to buy the underlying stock. However, it becomes obligation on the part of call writer to buy the underlying stock for the call holder when he exercises his rights. The option buyer (holder) has to pay the premium to the seller (writer) in exchange for the right conferred by the option. The premium depends on the strike price, volatility of the underlying stock, and time remaining to expiration. Writing covered call involves selling the call option on a long common stock position. An option writer, however, enjoys all the rights including the right to vote and the entitlement of dividends among others. Moreover, he is exposed to same risks as if the call option had not been written such as fluctuation in the price of the underlying stocks.

This strategy will outdo (works better) if any stock holder is maintaining the same position in stock market alone when the stock price falls, remains stable or rises modestly  during the expiry period of the call option. If the call holder doesn’t exercise his option, this strategy generates income for the portfolio as the call writer retains both stock and the premium. However, there is opportunity cost (loss) associated with writing call options. When a buyer makes profit, the seller makes a loss of equal magnitude and vice versa. This can be illustrated with a simple example.

Let us suppose an investor buys 100 common shares of SBI at Rs 2, 000.00 per share on 20st March 2014. He then sells on 21st March, 2014 call option at Rs 100.00 (strike price being Rs 2022.00). The option expires in 30 days. If, at expiry, the option trades at Rs 2,076.15 and an option is exercised by the call option holder. The call writer would lose (Rs 2076.15 – Rs 2022.00) = Rs 54.15 per share. This is opportunity cost for the option writer .So, if the option is exercised, upside potential on the underlying stock is limited to the strike price.  This is why the option writer should be neutral between retaining the shares and selling them at strike price when the stock price is too high.

Return on Investment

Strategy

Covered Call ( Buy Stock+ Sell Call)

(Cost in Rs)

The Pay Off Schedule

On expiry Nifty closes at Total Net Payoff from Call Option (Rs.)
Options

15000.00

3750.00

-3120.00

Spot Price

4050.00

3770.80

0.00

Mr Manish buys the Stock ABC Ltd Market Price

3850.00

3800.00

4380.00

Call Options Strike Price

4000.00

3850.00

11880.00

Mr Manish receives Premium

80.00

3900.00

19380.00

Min Lot Size

50.00

3950.00

26880.00

No. of order lot

3.00

3900.00

19380.00

Balance

3000.00

4000.00

34380.00

Other Charges including brokerage

0.80

4050.00

34380.00

From seller’s perspective Break Even Point= Stock price paid + other charges including brokerage -premium received

3770.80

4100.00

34380.00

Action

Exercise

4150.00

34380.00

565620 is the maximum risk faced when the stock price falls to zero profit/Loss per covered call

229.20

4200.00

34380.00

Total Profit/Loss

34380.00

4250.00

34380.00

Net Pay Off

When the Underlying Stock Price Falls

An investor who predicts a bear market on the underlying stock can take advantage of falling stock prices by selling a call option on the security. Let us consider the selling of a call option at the price (premium) c.

ST = Spot price at time T, K = exercise price

Profit = c if ST = K

For example, A sells 50 calls at a strike price of Rs 4000.00 for a premium of Rs 80.00 when the Nifty price was at 3800. Let us consider values of index at expiration at Rs 3950.00, Rs3800.00, and Rs 3700.00, Rs 3600.00

For ST = 3950.00, Profit = 3950-3850+80-0.80 = Rs179.20

For ST = 3850, Profit = 80- 0.80 = Rs 79.20

For ST= 3800, Profit = 80-0.80+3800-3850= Rs 29.20

If the stock price falls, the option will not be exercised by the option holder and the profit to the seller will be the premium- other charges including brokerage earned by selling the option which will offset a part of the losses incurred if call had not been written.

If the underlying shares fall more than expectation:

For ST= 3770.80, profit = 80- 0.80+3770.80-3850= Rs 0

For ST 3600, Profit= 80-0.80+3600-3850= Rs -170.80

In such a case, the call writer can exercise other options as well. They can either retain the stock or let the options expire naturally or they can close out the entire position by buying back the options and selling the stock in the market.

When the Underlying Stock Price Rises

Let us consider the selling of a call option at a premium, c.

ST = Spot price at time T, K = strike price, P= purchase price

Profit/Loss = c + (k-p) if ST >= K

For example, For example, A sells 50 calls at a strike price of Rs 4000.00 for a premium of Rs 80.00 when the Nifty price was at 3800. Let us consider values of index at expiration at 4100.00, 4200.00, and 4300.00.

For ST = 4050, Profit = (80-0.80) + (4100-100-3850) = Rs 229.20

Had the seller not gone for option, he would have made a profit of:

For ST = 4050, Profit = 4050- 3850= Rs 200

So, the seller is getting benefitted by writing the covered call when the spot price falls or rises modestly.

For ST = 4100, Profit = (80-0.80) + (4100-100-3850) = Rs 229.20

Had the seller not gone for option, he would have made a profit of:

For ST = 4100, Profit = 4100- 3850= Rs 260

So, the seller is not getting benefitted by writing the covered call when the spot price rises too high. Hence, this strategy works well if the stock price is predicted to be fairly stable or rise modestly. If it rises too high, then this strategy won’t be very useful.

If the rise in share price is more than expectation, the call writer can exercise other options. They can do nothing and potentially lose their stock at the strike price, or, they can buy back the options, allowing the underlying shares to rise without the risk of being exercised.

 Manish Kumar | T A Pai Management Institute, Manipal

1008890_10201574493788741_2030633216_o

Comments

3 comments