Options Strategy IV ( Writing Covered Calls )

In The last post we studied about stradles. In this post we will study about more conservative strategy that is writing covered calls. This is for those moderate investors who dont have high risk apetite.

Writing covered calls works when the stock is moveing sideways and not at all volatile. So this strategy complements Stradles. May be you hear about some boring stocks, which dosent move most of the times. You can use this strategey on those stocks.

All we have learned in the last post was buying an option, for writing covered calls we will look into sellng those stock options. By writing covered calls we mean selling stock options to be exact.

While buying stock option means that you have the right to buy stocks, but you are niot obligated to actually buy the stock options. Conversely, if you sell a call option, you now have the obligation to sell the stock to the option buyer at the agreed upon price at the specified date.

Now you might feel now thats a big risky investment. And who would do that. But the best part is when you write an option you recive the premium instantly and you make profits. Then why dont everyone start writing options :) ??

Just remember what we learnt before :- An Open position is created when you buy an option and the position is closed when u sell the option. Similarly, when you Write options, you write the option to Open the Position, and you must Close the Position somehow, whether it's by letting the option expire worthless, or by buying the option back.

The more the stock options are in the money, higher is the stock pricein case of Calls options. So if you sell the stock option and the price of the stock goes below the option will not be exercised and it will expire.

Let take a simple example here :-

You sell a stock option of TCS @ Rs 100 strike price at a premium of Rs 5. Now if the price of the stock goes below 100 then the person who bought this option from you will not exercise the option and it will expire and you will earn Rs 5.

however suppose the stocks keeps on climbing and reached 110 now the person will exercise the option and you will have to buy TCS stock ( @ 110 Rs ) and sell it to the person for Rs 100 and you will have a huge loss ( assuming the contract was of 100 shares) ( So in the first para we defined we should pick stocks which are not volatile but move sideways !!! ) We say that you were called out.

Therefore, selling stock options on their own, also known as selling Naked or Uncovered options, is extremely risky.

Now to reduce this risk what you need to do is buy the stock while you write the options. So you dont have to buy the stocks again at a much higher price. Suppose you want sell a contract of TCS shares you need to buy 500 TCS shares ( assuming that in a single contract there are 500 shares) @ 95 Rs ie the current market price. By buying the shares, we eliminate the risk of having to buy the shares later at a higher price in case we get called out. This is called covering your call writing, ie. we just wrote a Covered Call.

Let us take TCS example once again. This time you also bought the TCS shares at the current price (Rs 95) to cover you call. Now again two things can happen ( as always ! ) the price went up or it came down.

1) Suppose the stock price becomes 90. So the the person who bought your option will not exercise his option and it will expire worthless. So you will earn Rs 5 the premium of the call. Also you will lose out Rs5 on the stock. So overall your profit will be 0. Also you still own the stock. If you compare with just buying the stock you would have lost Rs 5 on every TCS stock you own. So actually you have increased your loss tolerance by Rs 5 as even if the price of the TCS stock goes below 5 you still dont lose anything!. SO you can call that your break even level. As long as stock stays above that level you will be in profit. Now the problem comes if the stock goes below your tolerance level. you will start having losses. That's why we need to look at stable or moderately bullish stocks to consider for writing covered calls.This is important in the stock market, where stocks we buy usually don't go up the way we expect them to...

2) Now of the stock goes up by Rs 20 say it becomes 120. Now you will be called out. but now you own the stock at Rs 95 so you can easily sell the stock and earn a profit of Rs 20 + Rs 5 ( ie the premium ).

Now let is again take point 1) where you still own the stock. Now you can again sell another option on the same lot of TCS stocks and earn the premium. So you can earn a cool monthly income by writing stock options. Unless you r unlucky enough and the stock price goes lower and lower. Now if the stock price goes higher you again earn profits!!

This is how investors write covered calls to generate a monthly income. This strategy usually earns about 3% to 15% a month. Not bad for a strategy that's almost risk-free! I hope you know Mr Gujral and heard about his trading academy. His tangline is 'Earn 30-40K / month without risking your capital". This is how this is done ;)

However, do note that if you are unlucky enough to choose to buy a stock that keeps falling lower and lower, no strategy is going to help you! (Unless you buy a Put option on that stock to reduce your losses :) (? try to figure this out yourself )).

Note :- Also suppose you own a stock which is not moving at all. You can start writing covered calls on that option and start earning montly income. And hopefully you get called out soon so you can get some profits out of that dead stock and invest it elsewhere.