Covered Call Option Strategy
We have seen how to construct single and multi-leg option strategies. This module will show you how to combine option strategies with buying or selling equity. These strategies will allow you to maximise your yield and hedge your losses. We will begin with the Covered call option strategy.
But, before we get to the strategy, let’s quickly get our basics in place.
We have briefly discussed that you can earn a yield through options. What does that mean? Let’s start with an analogy.
Assume you just purchased a new car. You can use this for the intended purpose of getting from point A to point B, but you realise that for a large portion of the day, the car sits unused. You decide to rent out your car on a short-term hourly basis. By doing this, your asset - your car - can earn you extra cash.
In a slightly different example, perhaps you recognise that you travel alone daily in a car that can seat five people. To make the most of this available space, you decide to use your car as an Uber driver. You only accept fares that are on your route home so there is a negligible difference in your daily commute. The benefit is that you earn additional money just by owning the car, taking the time to accept a fare, and driving your normal route.
In both these examples, you own an asset (your car) and are able to use that with minimal effort to earn cash (yield).
Carrying on with the Uber example, if your daily commute is very short, then the amount you can earn as an Uber driver is limited. However, if you have a longer commute, then your earning potential increases.
When you drive for Uber, Lyft (or deliver for Amazon), there are periods when there is high demand for drivers, but few people are interested in driving. This can occur when there is a major holiday, sporting event, or really bad weather. When this happens, drivers get paid far more. If your commute happens to occasionally coincide with these time periods, you can dramatically increase your income on those days.
In both the examples above, you are using your car to supplement your existing income. Just like how you earn from investing in stocks, bonds and other assets. Now let’s understand how you can use these assets not just to grow wealth, but also to earn a yield.
What is yield?
When you purchase a bond or invest in a bond fund, the bond will pay interest over time. If you buy this bond for ₹1,000 and it provides you with an annual interest payment of ₹20, your yield is 2%. You calculate this by dividing the income received by the value of the investment.
i.e. Yield = Income/ Value of investment
Similarly, you could decide to buy a stock that has a current price of ₹500 and pays a total annual dividend of ₹25. In this case, your dividend yield is 5% (25 / 500).
With stocks, you can earn a return based on an increase in the stock and you can also earn dividend yield. Say you buy the stock at 500 and the price moves upward from 500 to 600 over the course of a year, and you decide to sell. Your total return is the gain of 100 due to the increase in price (600-500) but also the gain of 25 from the dividend.
So how does this relate to options? If you own a stock, or are planning to own a stock, you can earn an additional yield through options.
How to earn yield using options
When you buy a call option, it gives you the right to purchase the underlying stock at a certain price within a certain time period. To buy the call option, you need to pay a premium upfront.
When you sell a call option, you have an obligation to sell the underlying at a certain price within a certain time period. When selling a call option, you receive a premium upfront.
Note here that while you do have an obligation to sell the underlying when you sell (or go short on) a call option, this only happens when the option has intrinsic value at expiry.
Let’s look at the table below and the real historical data for TCS. The current price of the stock is 3,211.15 and the bid price for a call option at the 3,280 strike is 59.95. The expiration date is in 30 days.
The price of TCS stock would need to rise from 3,211.15 to above 3,280, or gain 2.14%, in order for the call option to have intrinsic value.
If the stock closes at or below 3,280 on expiration of the call option, the trader will keep the entire premium of 59.95.
What happens if the stock closes above the strike price?
This is the biggest challenge with shorting call options. When this happens, losses will add up quickly. Since stocks can theoretically go up infinitely, your losses on a short call are theoretically unlimited.
One way to capture the yield with lowered risk is by trading ‘covered calls’ also known as a ‘buy-write’ strategy.
What is a covered call?
A covered call is when a trader owns a stock and then sells a call option on that stock.
Using the table above, let’s assume that you own TCS that is trading at 3,211.15.
If you sold the call option for 59.95 and TCS closes at or below the strike price of 3,280, then you will keep the full premium of 59.95. In this case, the yield you earn is 1.87% which is 59.95 divided by the TCS stock price when you sold the call option (3,211.15).
What is the profit potential?
When you trade covered calls, there are two ways to think about your potential return: ‘standstill return’ and ‘if-called return’.
The standstill return is exactly what it sounds like - the return if the price of the underlying is the same, or stands still, on expiration. If TCS doesn’t move from the price of 3,211.15, then there is no return associated with a change in stock price. The only return you will receive is the yield associated with selling the call option. Therefore, the standstill return is 1.87%.
The best-case scenario with a covered call is if the underlying stock trades up to the strike price of the shorted call option. In this case, you will keep 100% of your premium. This happens because the shorted call option will only have intrinsic value if the underlying stock is above the shorted strike price. You will also have a gain on the underlying stock due to the increase in price.
In our example, the strike price is +2.14% above the current price of 3,211.15. The yield from selling the call option is still 1.87%.
The ‘if-called return’ is 4.01% which is the sum of the stock price change and the yield from shorting the call option.
The ‘if-called return’ is the maximum gain for the covered call strategy.
What happens if the underlying stock closes above the strike price?
When you short a call option and the underlying stock closes above the strike price, any loss associated with the short call option will equal the gain associated with the long stock position.
If the trader receives a premium of ₹20 and the underlying stock closes 100 above the shorted strike price, then the net loss for the trader is 80 (100 - 20).
If the underlying stock closes 150 above the shorted strike price, then the trader’s net loss is 130 (150 - 20).
By owning the stock, any upside gains offset the losses of the shorted option. If the underlying stock closes 100 above the shorted strike, then the trader loses 100 on the short call but gains 100 on the long stock. At any price above the shorted strike price, the trader is perfectly hedged.
Illustration 3 below shows the profit diagrams for a long stock and a short call as well as how they combine to equal the covered call. As you can see in the covered call diagram, the green shaded section is capped – at some point, no matter how much the underlying price increases, you can’t make any more profit.
What are the benefits of this strategy?
- A trader can collect a yield by selling calls without the risk of unlimited losses that are associated with naked short options.
- If the trader is interested in owning the stock for the long-term, selling calls can possibly increase the total return.
- When the markets are more volatile, selling calls can act as a downside hedge. For example, if you earn a yield of 3% by selling a call option and a stock moves down 5%, your total return is -2% with the covered call strategy vs. -5% by just owning the stock.
What are the drawbacks of this strategy?
- If the stock moves upward significantly while you are shorting the call option, any stock gains above the strike price are offset by losses from the shorted call option.
E.g. If you sell a call option with a strike price that is 2% above the current price and the stock closes up 5% on expiration, then the only stock price gain you receive is +2%. Due to the shorted call option, you forgo the additional +3% gain.
When should you use a Covered Call strategy?
This strategy performs best when the market or an individual stock is trending upward slightly or is trading flat. The covered call strategy will outperform a stock-only strategy when the market or individual stock is moving downwards.
The covered call strategy will underperform a stock-only strategy when the market or individual stock is trending upwards significantly.
‘Stock-only’ strategy v/s Covered call strategy
The table below shows a backtest of holding a stock by itself vs. executing a covered call strategy.
In this covered call strategy, we are hypothetically selling a call on the Friday following monthly expiration. The call that is sold has an expiration date of one month and the strike we select is the one closest to being 5% out-of-the-money. What this means is that we will still retain a 5% gain in the stock for the next one month and we will also earn the yield from the sold call option.
Let’s orient you to this table. The first row shows the monthly returns of the stock only. The second row shows the monthly returns of the covered call strategy with the third row showing the difference between the covered call strategy and the stock only investment.
By looking at the third row, you can see the covered call underperforms when the underlying stock, Tata Motors, does really well. In July 2022 and October 2021, the trader would have lost on stock upside by trading the covered call strategy.
However, in all other months, whether the stock had a negative return or a slight positive return, the covered call outperformed. In this hypothetical example, the outperformance ranged from +2.1% to +5.2% per month.
What is the maximum loss?
The maximum loss is the value of the stock minus the premium received. With a covered call strategy you own the underlying stock which could theoretically lose 100% of its value. If the stock is trading at 200 and goes to 0, then you would lose that full amount.
However, this loss will be offset by the premium collected by shorting the call option. This is the profit formula for covered calls:
Covered Call Profit = Premium Received + Change in Underlying Price – Max(0, Underlying Price – Strike Price)
What is the difference between a Covered Call Strategy and a Buy-Write Strategy?
Fundamentally, there is no difference between the two names; the difference is in the implementation.
With a covered call, the assumption is that you already own the underlying stock and have decided to sell (or write) a call option against that stock.
With a buy-write, the assumption is that you are buying the stock and writing the call option at the same time similar to any of the other multi-leg option strategies that we have discussed.
How much yield can you earn with a covered call strategy?
When you invest in bonds, if you select a bond that is riskier, then you will generally receive a higher interest rate. Also, in most cases, if you purchase a bond with a longer investment period, you will receive a higher interest rate.
This is similar to selling call options. If you sell a call option on a riskier stock, you will receive a higher premium due to the higher implied volatility on the riskier stock.
If you decide to sell a call option with a longer time to expiry, you will earn a higher yield on the short call. This is similar to the higher yield on a bond with a longer duration.
In illustration 5, we list the price of two calls with 30 days to expiry. Both calls have strike prices that are approximately 2% out-of-the-money. However, Tata Motors has an implied volatility that is over 50% higher than that of TCS. The yield for the standstill return is significantly higher for Tata Motors than TCS due to this. As we’ve discussed previously, a higher volatility means that there is more of a chance that the stock could move up or down.
- Options strategies can earn you an additional yield on stocks you hold or plan to hold.
- In a covered call, the trader owns a stock and sells a call option on that stock
- Covered call reduces your losses from the option if the underlying price moves up.
- Covered call allows you to earn a yield from the stock.
- If you are holding the stock for the long term, selling calls could increase total return.
- Use a covered call strategy when the market or an individual stock is trending upward slightly or is trading flat.
- In volatile markets, use covered calls to hedge against falling stock prices.
- In a covered call, loss from selling option = gain from increase in stock price.
- Covered calls offer 2 types of profits: Standstill return and If call return.
- Standstill return is what you earn if the price of the underlying is the same on expiry.
- If-called return is what you get if the underlying stock price is above the strike price on expiry.
- The if-called return is the sum of the stock price change and the yield from shorting the call option.
- If-called return is the maximum gain in a covered call strategy.
- Maximum loss is the value of the stock minus the premium received.
- Premium from a covered call increases with increase in volatility of the underlying.
- Longer the time to expiry, higher could be the premium from a covered call.
Covered Call Profit = Premium Received + Change in Underlying Price – Max(0, Underlying Price – Strike Price)
The covered call strategy is one we can use if the underlying price is flat or moving slightly upwards. But is it possible to hedge one’s losses or earn a yield when prices fall? Yes, it is. We will show you how in the next chapter. See you there.
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