You Should not be Doing Covered Calls

This article is dedicated to my friends who asked a question on covered calls — Pallu aka Saurabh and Rakesh Hegde.


What is a covered call? 
You have Infosys, which you purchased at 900. You think the stock is stuck in a range, say 880–920. You sell a call against your stock and get some premium every month.

The first question is — which strike? Since 920 is the upper band according to you, you sell a 920 Strike call. This earns you around 20 Rs premium, a shade more than 2% of the stock value. So you earn 2% every month. And if the stock fails to cross 920, you make 2%x12 a year which is 24%. That is not bad.

Scenario 1: Infosys goes down

You make a profit on the call because the call options don’t get exercised and you earn the premium. But you make losses on the stock you hold.

If the stock goes down a little, your losses on the stock are offset by the premium. If it goes down a lot, then you lose more.

Scenario 2: Infosys Stays in the Band

You make a profit on the call because the call options don’t get exercised and you earn the premium. You make neither losses nor profits on Infosys.

This is also the best case scenario.

Scenario 3: Infosys Zooms Up

Till 920, you make no losses. At 20 Rupees premium, losses on the call till 940 is offset by 20 Rupees premium. After 940, your call makes losses. But that is compensated by the gains on your stock.

So if the stock breaks out and moves up around 10%, in a covered call scenario, you lose the potential for great gains in the stock and gain only the call premium. That is opportunity lost. But not losses.

Summary

If stock moves down a lot — You lose.
If stock stays in a range — You gain the premium.
If Stock moves up — You gain the premium.

But wait a second! That sounds like selling a put option!

So let us investigate:
I will compare two portfolios:
1) Infosys @ 900 + Sell INFY 920 Call @ 20
2) Sell Infy 920 Put @ 40

Here is the pay off from the two portfolios at various levels:

Covered Call Versus Sell Put

This looks exactly like sell put pay off diagram!

They are not just similar, they are identical!
Which means:
Covered Call = Sell Put!

How do we choose one over the other?
Let us assume you have nothing, to begin with. Your choices are:
1) Covered Call: Buy Stock, Sell an out-of-the-money Call
2) Sell Put: Sell an in-the-money put at the same strike as that of the call above.

So which one would you choose?
Obviously, 2
Because:
Lower capital requirement: In 1, you will need to buy the stock at full money, and sell the call paying the margin. In 2, you just need the margin.

Lower transaction charges: Covered call involves 2 transactions, of which one is a stock transaction which usually attracts higher transaction charges. A stock transaction’s STT is the biggest chunk. You can find out more here:

https://zerodha.com/brokerage-calculator

Lower Execution risk: One lot call option is 600 stocks. So you will have to buy 600 stocks at some price, and sell the call before the price moves down.

Takeaways

Covered call as a strategy makes sense only if:
1) You hold the stock and are planning to hold it for long.
2) You do not expect huge moves up.
3) You want to earn some extra yield on your existing stock portfolio.

If you do not have the stock, to begin with, there is no sense in doing the covered call. Always do sell put instead.

In many instances, you will be able to see if a strategy is similar to or the same as another strategy by looking at the payoff diagrams of the strategies. You can check that by loading the individual options into the Custom Strategies Builder by Sensibull —India’s First Options Trading Platform

If you have the stock, by all means, you can do covered calls.

Like it? Dislike it? Let us know in the comments!

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