March 15, 2010

Selling covered calls – An options approach

Some of you, on reading the title must be wondering – Rohit is again on his options trip ! this dude is going to get kicked big time, one of these days :)

Well, in the spirit of learning and experimenting lets look at an options strategy, that I think marries the value investing approach with options quite well.

What are covered calls?
You can read about call options
here. Selling covered calls mean selling a call option in the market while holding the underlying stock. Selling a call option without holding the underlying stock is naked selling (no its not selling without wearing your clothes :), but you could lose them if the naked selling bet goes wrong).

How does it work with value investing ?
The logic is as follows – Suppose you hold a stock which is a mid to long term holding. Lets say you bought the stock for 60 Rs and think the fair value is 100. Now let’s assume that the stock is selling for 95 and you plan to start exiting at 100-105 as you really do not want to hold above fair value. In such as case, one can sell a call on the stock for a strike price above the current quote, say around 110-115.

If the stock continues to climb, the call will get exercised and you will get the 110 exercise price + the premium amount. If the stock drops back and if you had planned to hold on to the stock for the long term as long as the price was below fair value and the fundamentals are good, then you pocket the premium and continue holding the stock.

An example
Lets take the example of a favorite of mine – Infosys technologies. My own estimates of fair value for the stock are around 2700-3000. The stock is currently selling for around 2700 which is close to fair value.

The first option for me is to sell the stock once the price crosses 2700 and be done with it. The other option is to start selling covered calls with a strike price of 3000 or higher. If the stock keeps rising and the call gets exercised, then I will end up exiting at 3000 + premium as planned. On the contrary if the stock drops from here, I can pocket the premium for free. The flip slide is that I will lose money on the stock as it drops.

The risks
If someone ever tells you that there is no risk in an investing strategy, ask him what he is smoking or drinking.

There are several risks in the above plan and it works only for a very specific situation. I would sell a covered call on a stock which I think is selling close to fair value and I would not mind holding it if it dropped below this price – the second part of the statement being the key. As a corollary, the reason I would not mind holding if the price dropped is because I think the company will continue to do well and will increase its intrinsic value at a good rate.

A valid question would be – why not sell and move on? . One reason for trying this approach is plain experimentation – with limited amounts of the stock. The second reason is that I would continue to hold on to the stock for the long term as the company is still doing fine and selling covered calls increases my returns. At the same time if the stock gets too overvalued, I would exit it by selling via the covered call.

If you do not want to hold the stock for the long term and would regret holding it if the price drops, then one should just sell the stock and move on. In summary this is a strategy of trying to be a bit too clever and squeezing out a few percentage points of returns.

As an aside which options should one sell in this case ? – I would prefer to sell the ones with the longest duration (May 2010 exercise) as I would also benefit from the
time decay and the premium is also worth the effort.

19 comments:

Anonymous said...

holding stock + selling call is economically the same as shorting puts and holding long a riskfree bond (by put call parity). Would you be comfortable being short puts?

Rohit Chauhan said...

hi anon
how will be a covered call be equivalent to a short put and long bond ? dont i require the underlying to execute a covered put startegy too?

anurag said...

Dear Rohit,

Addressing you,as per your wish:))

One more strategy a trader can expriment is that many a times in a month a Stock will be trading in premium to the CMP,in that case we can buy in cash and short one lot of future,and anyways on the closing of expiry the CMP and Futures rate will be same.and one can exit both the future and cash holding at the same time.

Regards
Anurag Awasthi

Rajkumar said...

Anon uses the put call parity relationship to create a synthetic portfolio. To identify arbitrage situations what he says is correct.

Anon,

Correct me if I am wrong. Your observation about covered call having the same responsiveness as that of a short put is correct. However, in this case Rohit does not write puts rather he writes "out-of-the-money" calls with an intention to sell off his underlying stocks if the option is exercised.

Additionally, his approach is to wait for the stock to reach fair value, and he is definitely not going to sell the stock if the price falls down. Since he expects the stock to reach fair value and then sell it off, and has a long expiration time. So effectively he will gain from the premium for writing calls.

Anonymous said...

i'm using the put call parity argument (may want to look it up).

the economics of a covered call is equivalent to writing naked puts (not covered puts). The two strategies can be used differently in terms of risk management though. But, its a useful mental exercise to consider the equivalence and the possibilities. So, just wanted to point it out.

Rohit Chauhan said...

Hi anurag
i agree , thats one startegy where one arbitrage the price difference. quick question though - i assume the price differential would quite small and would require some leverage and good trading skills to make a respectable return ?

rgds
rohit

Rohit Chauhan said...

Hi rajkumar
you described the strategy perfectly. its not a pure derivatives based arbitrage. the down is not protected if the stock drops, but then i am not looking for that protection either

hi anon - you are right ..but in my case naked put writing is exposes me to downside risk
In case of the specific covered call i have created, i have the same downside risk, but it would be temporary quotation loss for me as i will continue holding the stock (its a long term holding).
In case of short put, the short term loss will become a realised loss (and not a quotational loss alone)

rgds
rohit

Rajkumar said...

Dear Rohit,

Yes to exploit Anurag's strategy you need leverage and quick execution. Most pure arbitrage and hedge strategies magnify the returns with higher leverage. One has to watch the market frequently and closely to spot such arbitrage in the market. In Indian market index options are traded more by speculators and stock options market does not see high turnover to provide such opportunities frequently. Normally, I have noticed such opportunities in near month expiry options.

Regards,
/Rajkumar

anurag said...

Dear Rohit,

Leverage position in stock market can be very risky,and some brokerage house gives high speed trading platform like ODIN,which is very good for these sort of small but safe returns.

and we should also keep in mind that many a time the same stock will be trading in that particular month in discount,so your returns are slightly better.

And for Risk part I like your quote 'If someone ever tells you that there is no risk in an investing strategy, ask him what he is smoking or drinking'.

and even when you write a covered call then also you need to keep enough Margin in your account,coz many a time operators trap the retail in option trade.

Regards
Anurag Awasthi

Anonymous said...

DEAR ROHIT, HAPPY UGADI
WOULD IT BE TOO MUCH IF I ASK U WHICH STOCKS IN UR PORTFOLIO ARE GOOD FOR SUCH A STRATEGY.
I HAVE SHORTLISTED FOUR OF THEM.
HOPE MY CHOICE IS CORRECT
REGARDS

Rohit Chauhan said...

Hi rajkumar
i thought so..with thin margins it would require high leverage and sophisticated trading skills ..maybe even program trading

Rohit Chauhan said...

Hi anurag
i think i require margin for writing naked calls. in covered calls, i should be ok. if the stock drops, the call drops in value

if the stock rockets, then basically i think the stock gets assigned at around 5% or less below the strike price. i will be fine with that happening too. even if call works against me, worst case i can sell the stock and close the call.

i could lose or gain depending on the time left for expiration and the current volatility...again for long dated calls the sensitivity is low

anurag said...

Dear Rohit,

I did posted few TA levels,despite knowing that you do not give much importance to it.

I just wanted to to inform that whatever Nifty futures I bought at sub 4700,have been squared today at 5250 levels.I will be travelling and will not be able to follow up my calls,so as a I duty towards other member of your blog,i wanted to update.

Sirji,will interact you again in May 2010.

Happy Investing

Regards
Anurag Awasthi

Rajkumar said...

Dear Rohit,

I like your current strategy (using covered calls) with expiration value slightly above your estimated fair value. Basically, you are increasing your returns from the same stock just before selling it off WOW! Some might contest you are restricting the upside, but you intend to sell it off when fair value is reached anyways.

I have a request. I read the post about Elantas de-listing was very informative. Do you guys have something similar for merger arbitrage. Basically, the sequence of steps involved and when should a value investor enter and what things to keep in mind?

I read Warren's statements about his approach somewhere on their website and I dont remember. If you could share something it would be beneficial.

Thanks,
/Rajkumar

Rayhaan said...

hey rohit,
read about covered calls in the intellegent investor(jason zweig is a little against them) ,i mean isnt it like cutting off ur upside too(say if the fundamentals improve and the intrinsic value increases)?
by the way( i know this looks like im getting my homework done by you for free) what do u think about these 3 (hopefully undervalued stocks) companies-
1)temptation foods
2)compact disc
3)wim plast
any comments would be gr8 help for this amateur!!!!!!!!

mkd said...

Hi Rohit,

In low volatility environment, this strategy definitely works as there is less likelihood of having to sell the underlying and more probability of options expiring worthless (or at lesser value than premium received.)

However, the main risk in this strategy is 'being forced to sell the underlying' to cover the Call-Option loss in case of increase in price.

So it should probably be pursued only with stocks that you have no problem selling any given day above your strike price plus premium.

If there is any expectation of market re-rating, specific industry re-rating, company re-rating, huge earning surprise etc., then one should be careful with this strategy.

I learned this the hard way after paying a huge 'tution fee' last May, when there was a sudden gap-up in markets after election results. Had to sell all my 2008-firesale underlying which over next few months would have given my xyz notional profit.

Anyway, since I am ready to make mistakes again :-), am exploring the possibility of this strategy with Bharti.

Another application of this strategy that I am exploring is doing it with NIFTY instead of individual stock. I am still trying to figure out
1) the tracking lag between underlying (NIFTY ETF) and NIFTY strikes
2) Impact on such a strategy due to NIFTY options being European compared to individual stock options being American

As you said, I will be more than happy if I can make such a strategy pay for my monthly coffee.

mkd

Rohit Chauhan said...

Hi rajkumar
we have not started working on merger arbs yet. however we are working on some demerger deals though. the process to a certain extent is similar.
i will post on the approach and an idea in due course soon

rgds
rohit

Rohit Chauhan said...

Hi rayhaan
by writing covered calls, i am capping my upside. but i am executing it in a case where i would anyway sell the stock beyond its fair value.
in this case i am writing the call at 10%+ my fair value estimates. so i dont mind selling off my holding at this price.

i have not analysed these companies and will update when i do so
rgds
rohit

Rohit Chauhan said...

hi mkd
i would prefer sell when the implied volatility in the option is high. that way there is a double benefit ..you get a benefit with time decay and similarly if the volatilies reduces the value of the option reduces. this works well for the seller

i would execute this strategy only if i would anyway sell the stock at the strike price, never otherwise.

i would never sell covered calls on undervalued stock due to the risk you mentioned. the idea is to sell on overvalued stock to get a little extra return. also i am comfortable with the downside risk and will hold the stock if it dropped.otherwise i would have just sold the stock and not get into all this

i have not looked at options on nifty as i think it gets into areas which are quite beyond me. for starters it may not involve fundamental analysis