Should you write Covered Calls on portfolio stocks?

Earning high returns without taking any risk is the holy grail of investing. Scores of fund managers and investment professionals are working relentlessly to find such opportunities. However, time and again it is taught by markets that finding such opportunities is easier said than done. But not for a new class of “Social Media Financial Experts”. In Telegram channels, Youtube videos, and WhatsApp groups there is a free flow of such risk-free ideas by these so-called experts. One of such widely shared ideas is the “Covered Call” strategy. Popular slogans used to define this strategy are

• Earn risk free rental income from your stocks

• Generate extra 10-20% risk free return on your stocks

Is there is any truth behind these catchy slogans? Should you write call options on your portfolio stocks? Does it generate additional returns without any risk?

Let’s find out

What is Covered Call?

This is how a covered call strategy works. Buy shares of a company that is part of the F&O list. The minimum long position has to be one lot of F&O. Simultaneously, you write an OTM call option on the same company shares (equal to the number of shares held in the long position). Earn a premium for writing these call options.

A naked call option has unlimited risk but not in the case of a covered call writing. Any loss in the call option position due to a rise in the share price beyond the strike price will be offset by the corresponding increase in the value of shares owned in the long position. So, you will not be exposed to the risks that are there in a naked call writing.

Long-term investors will typically have a long position in shares of various companies in their portfolios. The opportunity of getting some additional income by writing call options on their portfolio stocks is quite enticing. Depending on the strike price and time to expiry this premium can be substantial.

Let’s consider the example of ITC, a darling of covered call writers.

For a strike price of 230 and an expiry date of 27/01/2022, the call writing premium is 4.95 per share. This is a 2.26% flat return in just 41 days which works out to be ~22% on an annualized basis. This indeed is quite substantial. In comparison, NIFTY 50 TRI has generated returns of only ~18% over the last 5 years.

With no incremental downside risk and substantial premium, this strategy does look good. Right?

Let’s calculate pay-offs to find out.

Pay-off structure

By writing covered calls, in lieu of the premium, you forgo the right for any capital appreciation above the option strike price. For stock investments, most of the returns come from capital gains and not from dividends. NIFTY 50 dividend yield is even less than 2%.

Continuing with the example of ITC:

Current share price	220
Lot size (No. of shares) (a)	3,200
Strike price	230
Call option premium (per share) (b)	4.95
Transaction date	17/12/2021
Option expiry date	27/01/2022
Total premium for 1 lot = (a) x (b)	15,840
Premium (as % of long position – on annualized basis)	21.91%

If the stock price on expiry is more than the strike price, you will not get any benefit of stock appreciation over and above the strike price. The loss in the call option will offset the gains to some extent:

Stock price on maturity	250
Gain in long position	+30
Loss in call option	-20
Net gain	+10

But only with call option premium itself, annualized return works out to be ~22%. Even if no capital appreciation is assumed, the annualized return (including a dividend yield of 4-5% for ITC) works out to be in excess of 25%. This is quite a healthy return. Also, risk on account of fall in share price is also reduced to the extent of premium collected.

	Portfolio without call option writing	Portfolio with call option writing
Stock price on maturity	200	200
Loss in long position	-20	-20
Call writing premium	0	4.95
Loss in call option	0	0
Net gain/(loss)	-20	-15.05

With more than 25% upside potential and lower downside risk, this indeed looks like a great deal. So, the “Experts” are in fact right on this?

Not so fast !!!

Let’s scratch the surface and go a bit deeper.

If there is no call option writing, the gain/(loss) will only depend on the purchase and sales price of the security. The path taken by the stock to reach the price on which stock is finally sold has no impact. But once call writing is included in the mix, the path taken by the stock becomes important.

Consider three different price movement scenarios of ITC stock for the period between 17th Dec 2021 and 31st March 2022.

Transaction

• Buy 3,200 ITC shares on 17th December 2021 at a price of 220

• Write call option on 3,200 ITC shares (1 lot) on 17th December 2021 with strike price of 230 for 27th Jan 2022 expiry

• On expiry of January call option, buy another call option on same date for 24th Feb 2022 expiry

• On expiry of February call option, buy another call option on same date for 31st march 2022 expiry

• Sell 3,200 ITC shares on 31st March 2022

• Strike price is taken at 10/- higher than the spot price for writing February and March expiry options

Call option expiry dates	Premium/share	Strike price – scenario 1	​Strike price – scenario 2	Strike price – scenario 3
27 Jan 2022	4.95	230	230	230
24 Feb 2022	3.5	240	260	260
31 Mar 2022	3.5	255	230	290
	11.95

Scenario 1:

• Collect aggregate premium of 11.95/ for option writing

• On 27th Jan 2022: With both spot price and strike price at 230, there will be no loss on the option

• On 24th Feb 2022: With spot price at 245 and strike price at 240, there will be a loss of 5/- on the option

• On 31st March 2022: With spot price at 220 and strike price at 255, there will be no loss on the option

• On 31st March 2022: With spot price at 220, there will be no gain/loss on share sale

• Aggregate gain of 6.95/- on the transaction

Scenario 2:

• Collect aggregate premium of 11.95/ for option writing

• On 27th Jan 2022: With spot price at 250 and strike price at 230, there will be a loss of 20/- on the option

• On 24th Feb 2022: With spot price at 220 and strike price at 260, there will be no loss on the option

• On 31st March 2022: With spot price at 220 and strike price at 230, there will be no loss on the option

• On 31st March 2022: With spot price at 220, there will be no gain/loss on share sale

• There will be aggregate loss of 8.05/- on the transaction

Scenario 3:

• Collect aggregate premium of 11.95 for option writing

• On 27th Jan 2022: With spot price at 250 and strike price at 230, there will be a loss of 20/- on the option

• On 24th Feb 2022: With spot price at 280 and strike price at 260, there will be a loss of 20/- on the option

• On 31st March 2022: With spot price at 290 and strike price at 290, there will be no loss on the option.

• On 31st March 2022: With spot price at 290, there will be gain of 70/- on share sale

• Aggregate gain of 41.95/- on the transaction

	Scenario 1	Scenario 2	Scenario 3
Payoff with covered call writing	6.95	-8.05	41.95
Payoff without covered call writing	0	0	70

In scenario 1, the payoffs are better with covered call writing. However, in the other two scenarios, you are better off without call writing.

A long-term investor has two disadvantages in using covered call strategy:

• With only a stock position, such investor is not worried about intermittent volatility and can benefit from long term price appreciation of the stock. Writing covered calls makes even such an investor susceptible to intermediate volatility

• By writing call options, investor’s stock price appreciation returns are capped. Just for a small premium investor will have to forgo the entire upside

“Experts” shouting rental income never told you this. Anyways, now you know and can make better-informed decisions.

There are a few more things that investors must keep in mind before embarking on the adventure of covered call writing.

Minimum Investment threshold

For following the covered call strategy at least one lot of any share needs to be purchased. The amount required to buy one lot varies from company to company. Typically, this value is in the range of 5-10 lakhs. Any investors need to keep at least 10-15 stocks in the portfolio for diversification benefits. So, even with 10 stocks in a portfolio with an average lot value of Rs. 7 lakhs, the portfolio size works out to be in excess of Rs. 70 lakhs.

Investors with a smaller portfolio than this will have to allocate much more capital to one stock. Since the investor is fully exposed to downside risk, such concentration in one stock will increase the portfolio risk beyond the acceptable thresholds.

Stock selections

Based on parameters like expected volatility, market direction, and demand and supply, option premiums will be different for different companies. At times, investors can be tempted to buy a stock just because the option premium on such stock is high. Buying such stocks without conviction can be disastrous for the portfolio.

Active involvement

Covered Call strategy requires the active involvement of investors. Investors need to write calls on a regular basis. Adverse movements in call option prices might trigger margin requirements. In case, the margin is not provided on a timely basis, the broker will liquidate the position. To avoid this, Investors need to continuously monitor their positions. Investors who like to follow a passive buy-and-hold strategy may find this active involvement tedious.

Long-term investors should avoid writing covered calls. They will get more benefit by using their time in finding the right stocks which they can hold for the long term.