• Investment World
• eWorld
• Catalyst
• Mentor
• Life
• Canvas
• Praxis
• Urban Pulse
• Brand Quest

I AM holding 10,000 shares of HLL and 5,000 shares of Ranbaxy. One of my friends who is regularly trading in derivatives advised me that these shares could be used for earning money in arbitration option. He said that these shares would generate extra amount if I sell them on call. Is it possible? Kindly explain with an example. As I am a senior citizen, this is the only source of income. — Mehta Hemant

Your friend's advice to help you earn some extra money from the shares you own is possible. This is known as covered call writing. It is probably one of the safe ways for an investor to become involved with stock options. It essentially allows an investor to be paid twice for the ownership of their stock.

Writing a call

Covered call is an option strategy with which you sell a call against shares that you already own. It is simply selling an out-of-the-money call option against the stock that you already own.

The premium charged for a call consists of `intrinsic value' and the other is the `time value'. Intrinsic value is simply what you would realise if the option were about to expire immediately. An option's market value will generally exceed its intrinsic value by an amount that is called the option's time value. A call is said to be out-of-the-money the underlying value is less than the strike price. In other words, it has zero intrinsic value.

In your case, you own 10,000 shares of HLL and 5,000 shares of Ranbaxy. To write a covered call, you have to have three things in mind.

* This strategy works best if practiced in neutral to bearish market conditions.

* The call is out-of-the-money. Suppose, the strike of Ranbaxy June call is 660 and the spot Ranbaxy is quoting at Rs 642.60, then your call is out-of-the-money.

* It is also critical that you not sell an option with more than 30-45 days until expiration to benefit from the increased rate of time decay. Time decay is change in an option price to the decrease in time to expiration.

* Since all stock options decay over time and the rate of decay increases in the month of expiration, it is recommended that you never sell an option that has more than 30-45 days until expiration.

Let's say that you have a view that the Ranbaxy stock remains neutral (not much of a change in the spot price). So now, you have to choose a strike price high enough that the stock will probably not reach prior to expiration. The permitted lot size of Ranbaxy is 800 contracts. You sell 800 contracts of the Ranbaxy June 660 call for a premium of Rs 8,880 (800*11.10). This will be credited to your account. By writing the call option, you earn the premium, however, the risk of sharp increases in price and consequent loss exists.

Now, let's look at what happens if the stock increases or decreases in value.

Stock Price Goes Up: If the stock price rose to a level just below the strike price of our option, on expiration day (i.e. Rs 658 per share) the option would expire worthless and you have effectively earned the premium.

If the stock were to rise above the option strike, price prior to expiration day (i.e. Rs 665 per share), the 660 June call turned in-the-money for the call holder. All in-the-money calls are automatically exercised. Following cash settlement in India, you have to pay the difference between the spot and the strike. In this case, it is Rs 5 per share.

# This is the risk associated with this strategy.

# If the stock price increases sharply, you stand to lose the difference between the spot and the strike.

# The higher the spot rises the greater is your loss.

# The overall gain is premium received - (spot - strike)

Stock Price remains the same: If the stock price were to remain range-bound (640-645) then option would expire, which leaves you with the premium.

Stock Price Goes Down: If the stock was to decline in value (i.e. Rs 630), the option expires worthless as it is out-of-the-money and you could keep the Rs 8,880 call premium.

Suitability: This strategy though may seem risk less, has its downfall. You stand to lose heavily if the underlying security price increases drastically.

Note: This strategy works best if practiced in neutral to bearish market conditions.

Query corner

If you have any queries relating to the futures/options markets and strategies that can be used in these markets, please mail them to Futures & Options, Kasturi & sons, 859-860, Anna Salai, Chennai 600 002 or email them to vaidy@thehindu.co.in with a mention of futures/options in the subject line of the mail.

C. Raja Rajeshwari

Article E-Mail :: Comment :: Syndication

Stories in this Section
Frontline software companies — Strategising when bottomlines byte

Copyright © 2003, The Hindu Business Line. Republication or redissemination of the contents of this screen are expressly prohibited without the written consent of The Hindu Business Line