Covered call is one of the most used and basic options strategy that one can use to hedge a security held in a portfolio. Although it needs little practice to understand the workings of covered call, it is pretty straight-forward to learn with Alpha Trader.
Before we jump into a covered call, let us revisit some basic concepts related to Options Trading in Indian Markets.
- In Indian equity markets we have European style of options trading
- CE – Call European & PE – Put European
- One buys call when bullish sentiments are predominant
- One buys put when bearish sentiments are predominant
- There is another way – Options Writing which includes selling a call and selling a put
- There are two types of options expiry – Weekly & Monthly
To understand how can one hedge a security held in portfolio against possible downfall we will take an example of Bajaj Finance.
Note: Covered call requires you to have exact number of shares to be held in your DMAT account as that of lot size. For e.g. Bajaj Finance lot size is 250, so you can initiate a covered call with this holding. If you have fewer than 250 shares, you will not be able to execute this strategy by your broker
Example – Bajaj Finance: 250 shares held in DMAT
Here is the scenario –
- We have bought 250 shares of Bajaj Finance at 3350 and we want to protect this position against possible downfall
- Total amount invested is 8.375L
What if I told you that even if Bajaj Finance remains near 3350 for next entire month, you can make a decent money just by executing a covered call?
First thing we must do is look at a daily chart of Bajaj Finance. Here is that for an easy reference.
Here is the monthly chart for Bajaj Fiance for additional reference
So first step done – We have found out where daily & monthly support levels exists. This is very important step.
From above image it is evident that highest OI is at 3500 and most probably Bajaj Finance will not be able to cross 3500 that expiry.
So second step done – We have found out where highest call OI exist to know maximum level Bajaj Finance can climb
Covered Call Execution
Step One: Sell Bajaj Finance 3500 CE when spot price is 3350. Also note that for this example I have specifically taken real example where I executed the position with 10 lots. If one does with ONLY ONE lot, then calculations will change and range of protection will be much smaller.
Ask is 27.50 and bid is 26.95. SO let us say we placed limit order at 27.30
The moment we write this call, we earn 27.30 X 250 = 68,250/-
Possible Scenarios since call writing
Following are possible scenarios at the time of expiry
Price remains at 3350
- We get to keep 68,250 with our obligation of selling the stock released.
Price at 3450
- We get to keep 68,250/- plus we get (3450 – 3350) x 250 = 25,000. Total 68,250 + 25,000 = 93,250/-
- This additional 25,000 has come from profit in your cash position
Price below 3350
Remember we made initial gains of 68,250, so downside is protected by option premium until it exhausts 68,250.
Let us find out until what price are we protected when we write this call:
837500 ( Cash deployed to buy 250 stocks ) – 68250 ( Options Premium Earned) = 7,69,250/-
769250/250 = 3077
That means even if price falls to 3077, we are protected.
That means as long as price remains between 3077 to 3500, we will end up in profit. How much profit will depend on what level price expires at. Best gain is when price expires between 3350 and 3500.
Price below 3077
When price drops below 3077, you do not end up in loss on your option as your option is still OTM and you get to keep 68,250 you initially made.
But when price starts dropping below 3077 you start getting in paper loss or a notional loss on value of the stock you hold in your account.
This example shows that covered call strategy for Bajaj Finance protects for any downside from 3350 to 3077.
Loss Scenario for Option
If Bajaj Finance expires at 3501 then your entire DMAT holdings of stock (250) gets called away from your account immediately. This is automatic. Therefore, if you execute a covered call, you must hold entire 250 stocks in your account. Otherwise, your broker will not allow you to execute this strategy.
Much Lower Price – Lower than 3077
Let us now consider a scenario, where price might fall to 2800
Your downside risk is protected until 3077 from covered call.
However, you also want to cover for any risk below 3077. Then you need to supplement your covered call strategy with a collar where we but OTM puts. As Puts start gaining more premium as price falls, it provides cushion for any fall after 3077.
For e.g. you buy OTM put say 2900 PE at the time you executed the covered call. So this strategy to cushion your risk is now called as Collar.
So not only you are protected from any downside until 3077 when you bought Bajaj Finance at 3350, but also you are covered for further risk from downfall by buying OTM put at 2900.
Essentially, your covered call provides you profit until 3077, and from that point onward, your put starts providing profit.
In sum, when you buy Bajaj Finance in portfolio with intention of holding it for a long term, you not only cover for downside, you also make consistent income from holding the stock in your account.
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