STRATEGY 7 : COVERED CALL : BUY STOCK + SELL OTM* CALL
*OUT-OF-THE MONEY
You own shares in a company which you feel may rise but not much in the near term (or at best stay sideways). You would still like to earn an income from the shares. The covered call is a strategy in which an investor Sells a Call option on a stock he owns (netting him a premium). The Call Option which is sold in usually an OTM Call. The Call would not get exercised unless the stock price increases above the strike price. Till then the investor in the stock (Call seller) can retain the Premium with him. This becomes his income from the stock. This strategy is usually adopted by a stock owner who is Neutral to moderately Bullish about the stock.
An investor buys a stock or owns a stock which he feel is good for medium to long term but is neutral or bearish for the near term. At the same time, the investor does not mind exiting the stock at a certain price (target price). The investor can sell a Call Option at the strike price at which he would be fine exiting the stock (OTM strike). By selling the Call Option the investor earns a Premium. Now the position of the investor is that of a Call Seller who owns the underlying stock. If the stock price stays at or below the strike price, the Call Buyer (refer to Strategy 1) will not exercise the Call. The Premium is retained by the investor.
In case the stock price goes above the strike price, the Call buyer who has the right to buy the stock at the strike price will exercise the Call option. The Call seller (the investor) who has to sell the stock to the Call buyer, will sell the stock at the strike price. This was the price which the Call seller (the investor) was anyway interested in exiting the stock and now exits at that price. So besides the strike price which was the target price for selling the stock, the Call seller (investor) also earns the Premium which becomes an additional gain for him. This strategy is called as a Covered Call strategy because the Call sold is backed by a stock owned by the Call Seller (investor). The income increases as the stock rises, but gets capped after the stock reaches the strike price. Let us see an example to understand the Covered Call strategy.
When to Use: This is often employed when an investor has a short-term neutral to moderately bullish view on the stock he holds. He takes a short position on the Call option to generate income from the option premium. Since the stock is purchased simultaneously with writing (selling) the Call, the strategy is commonly referred to as “buy-write”.
Risk: If the Stock Price falls to zero, the investor loses the entire value of the Stock but retains the premium, since the Call will not be exercised against him. So maximum risk = Stock Price Paid – Call Premium
Upside capped at the Strike price plus the Premium received. So if the Stock rises beyond the Strike price the investor (Call seller) gives up all the gains on the stock.
Reward: Limited to (Call Strike Price – Stock Price paid) + Premium received
Breakeven: Stock Price paid - Premium Received
Example
Mr. A bought NIFTY for Rs 5846.70 on 16 Sept 2010 and simultaneously sells a Call option at an strike price of Rs 6000. Which means Mr. A does not think that the price of NIFTY will rise above Rs. 6000. However, incase it rises above Rs. 6000, Mr. A does not mind getting exercised at that price and exiting the stock at Rs. 6000 (TARGET SELL PRICE = 2.62% return on the NIFTY purchase price). Mr. A receives a premium of Rs 18 for selling the Call.
Thus net outflow to Mr. A is (Rs. 5846.70 – Rs. 18) = Rs. 5828.70. He reduces the cost of buying the NIFTY by this strategy. If the stock price stays at or below Rs. 6000, the Call option will not get exercised and Mr. A can retain the Rs. 18 premium, which is an extra income.
If the stock price goes above Rs 6000, the Call option will get exercised by the Call
buyer. The entire position will work like this :
Strategy : Buy Stock + Sell Call Option
Mr. A buys the NIFTY Market Price (Rs.) 5846.70
Call Options Strike Price (Rs.) 6000
Mr. A receives Premium (Rs.) 18
Break Even Point (Rs.) (Stock Price paid - Premium Received) 5828.70.
Example :
1) The price of NIFTY stays at or below Rs. 6000. The Call buyer will not exercise the Call Option. Mr. A will keep the premium of Rs. 18. This is an income for him. So if the stock has moved from Rs. 5846.70 (purchase price) to Rs. 5946.70, Mr. A makes Rs. 118/- [Rs. 5946.70 – Rs. 5846.70 + Rs. 18 (Premium)] = An additional Rs. 18, because of the Call sold.
2) Suppose the price of NIFTY moves to Rs. 6100, then the Call Buyer will exercise the Call Option and Mr. A will have to pay him Rs. 100 (loss on exercise of the Call Option). What would Mr. A do and what will be his pay – off?
a) Sell the NIFTY Long Position(5846.70) in the market at : Rs. 6100
b) Pay Rs. 100 to the Call Options buyer : - Rs. 100
c) Pay Off (a – b) received : Rs. 6000 (This was Mr. A’s target price)
d) Premium received on Selling Call Option : Rs. 18
e) Net payment (c + d) received by Mr. A : Rs. 6018
f) Purchase price of NIFTY. : Rs.5846.70
g) Net profit : Rs. 6018 – Rs. 5846.70 = Rs. 171.30
h) Return (%) : (Rs. 6018 – Rs. 5846.70) * 100 /5846.70 = 2.92% (which is more than the target return of 2.62%).
STRATEGY 15. BULL CALL SPREAD STRATEGY: BUY ITM* CALL OPTION + SELL OTM* CALL OPTION
*IN-THE- MONEY
*OUT-OF-THE MONEY
A bull call spread is constructed by buying an in-the-money (ITM) call option, and selling another out-of-the-money (OTM) call option. Often the call with the lower strike price will be in-the-money while the Call with the higher strike price is out-of-the-money. Both calls must have the same underlying security and expiration month.
The net effect of the strategy is to bring down the cost and breakeven on a Buy Call (Long Call) Strategy. This strategy is exercised when investor is moderately bullish to bullish, because the investor will make a profit only when the stock price / index rises. If the stock price falls to the lower (bought) strike, the investor makes the maximum loss (cost of the trade) and if the stock price rises to the higher (sold) strike, the investor makes the maximum profit. Let us try and understand this with an example.
When to Use: Investor is moderately bullish.
Risk: Limited to any initial premium paid in establishing the position. Maximum loss
occurs where the underlying falls to the level of the lower strike or below.
Reward: Limited to the difference between the two strikes minus net premium cost. Maximum profit occurs where the underlying rises to the level of the higher strike or above
Break-Even-Point (BEP): Strike Price of Purchased call + Net Debit Paid
Example:
Current NIFTY is at 5846.70 on 16 Sept 2010. Mr. XYZ buys a Nifty Call with a Strike price Rs. 5700 at a premium of Rs. 173 and he sells a Nifty Call option with a strike price Rs. 6000 at a premium of Rs. 18. The net debit here is Rs. 155 which is also his maximum loss.
Strategy : Buy a Call with a lower strike (ITM) + Sell a Call with a higher strike (OTM)
Nifty index Current Value 5846.70
Buy ITM Call Option Strike Price (Rs.) 5700
Mr. XYZ Pays Premium (Rs.) 173
Sell OTM Call Option
Strike Price (Rs.) 6000
Mr. XYZ Receives Premium (Rs.) 18
Net Premium Paid (Rs.) 155
Break Even Point (Rs.) Strike Price of Purchased call + Net Debit Paid : 5855
STRATEGY 17. BULL PUT SPREAD STRATEGY: SELL OTM* PUT OPTION + BUY PUT OPTION WITH LOWER STRIKE
*OUT-OF-THE MONEY
A bull put spread can be profitable when the stock / index is either range bound or rising. The concept is to protect the downside of a Put sold by buying a lower strike Put, which acts as an insurance for the Put sold. The lower strike Put purchased is further OTM than the higher strike Put sold ensuring that the investor receives a net credit, because the Put purchased (further OTM) is cheaper than the Put sold. This strategy is equivalent to the Bull Call Spread but is done to earn a net credit (premium) and collect an income.
If the stock / index rises, both Puts expire worthless and the investor can retain the
Premium. If the stock / index falls, then the investor’s breakeven is the higher strike less the net credit received. Provided the stock remains above that level, the investor makes a profit. Otherwise he could make a loss. The maximum loss is the difference in strikes less the net credit received. This strategy should be adopted when the stock / index trend is upward or range bound. Let us understand this with an example.
When to Use: When the investor is moderately bullish.
Risk: Limited. Maximum loss occurs where the underlying falls to the level of the lower strike or below
Reward: Limited to the net premium credit. Maximum profit occurs where underlying rises to the level of the higher strike or above.
Breakeven: Strike Price of Short Put - Net Premium Received
Example:
Mr. XYZ sells a Nifty Put option with a strike price of Rs. 5700 at a premium of Rs. 30 and buys a further OTM Nifty Put option with a strike price Rs. 5500 at a premium of Rs. 11.45 when the Current NIFTY is at 5846.70., with both options expiring on 30th Sept 2010.
Strategy : Sell a OTM Put + Buy a Put with lower strike
Nifty Index Current Value 5846.70
Sell Put Option Strike Price (Rs.) 5700
Mr. XYZ Receives Premium (Rs.) 30
Buy Put Option Strike Price (Rs.) 5500
Mr. XYZ Pays Premium (Rs.) 11.45
Net Premium Received (Rs.) (30-11.45) = 18.55
Break Even Point (Rs.) Strike Price of Short Put - Net Premium Received 5681.45
The strategy earns a net income for the investor as well as limits the downside risk of a Put sold.
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