Which IT Outsourcing Company Gives Maximum Return on Covered Calls?

In a covered call strategy, one buys the stock and sells its call, in return getting a premium. For people who are new to options, the following example explains a covered call strategy.

1. John buys 100 shares of Infosys Technologies (INFY) for $51.15. He pays $5,115 plus some commission of, say, $10. So the net amount he pays is $5,125.

2. He is bullish about the stock for the long term, but in the short term he feels the stock won't move much. So he sells a call for Jan-2008, for strike price of $55.00. In return he gets $4.00 per share as premium. So he gets $400 in return for his position. If the commission for the call is $10.00, the net return is $390.

3. The moment John invests $5,125 he gets $390 back, but by selling the covered call for Jan-2008 strike price of $55, John has limited himself with the gains he can make.

4. Let's say there is a stock market boom and by October 2007 INFY is at $60; nevertheless, John will have to sell his shares for $55 because he has already sold his call.

5. So, by selling at $55, John would make $3.85 per stock. Deducting the commission it becomes $370 for 100 shares.

6. With the investment of $5,125 he gets $390 + $370 = $740 which is 14% after 6 months, 28% per year.

7. Instead of increasing the stock nose dives to $45 by Jan-2008, John need not sell his shares because the share price is below the strike price of $55 for which he has sold his call. And he gets to keep his $390 that he got when he sold the call initially

From the above example it can be seen that a covered call is a great cushion for limiting one’s risk. The only thing that it does not cover is if the stock of the company just keeps on decreasing and never (say over the next 5 years) comes back to the price at which bought, in which case that call coverer would face a loss.

With the above tutorial on covered calls, let's see which IT outsourcing stocks would give maximum return on covered calls (assuming one wants to hold the stock position for more than six months).

NOTE : In order to sell a covered call one needs to have 100 shares of the company.

For calculating maximum return, I have considered the next higher call price than that of the stock price. For example, the next higher call price for INFY, whose stock is around $50.50, is $55.

For calculating minimum returns, it is assumed that one holds the stock for the long term and is not affected if the price of the stock goes down in six months.

The follow figures neglect the price of commissions:

Infosys (INFY)

Stock price on June-25 $50.50
Call premium for $55.00 for Jan-2008 = $3.70
If one buys 100 shares one would invest $5,050
Max return one would get = 14%
Min return one would get = 7.6% .

Wipro (WIT)

Stock price on June-25 $15.47
Call premium for $17.50 for Dec-07= $0.70
If one buys 300 shares one would invest $4,641
Max return is ($0.70 * 300) + ($17.50 - $15.47) * 300 = 829 = 17%
Minimum return one would get = ($0.70 * 300) = $210 = 4.5%

Satyam (SAY)

Stock price on June-25 $24.50
Call premium for $30 for Jan-08 = $1.25
If one buys 200 shares one would invest $4,900
Max return is ($1.25 * 200) + (($30 - $24.50) * 200) = $1,350 = 27.4%
Min return is $1.25*200 = $250 = 5%

Cognizant (CTSH)

Stock price on June-25 was $75.48
$80 call option for Jan-08 is $6.00
If one buys 100 shares , one would invest $7,548.
Max return one would get = ($6 * 100) + (($80 - $75.48) * 100) = $1,052 = 14%
Min return one would get = $6 * 100 = $600 = 7.9%

Conclusion

Looking at the above comparisons, I would prefer to have a covered call strategy with Satyam, considering its 27% max return limit. The variance in minimum return is very little; Cognizant is the highest at 7.9% and Wipro is lowest at 4.5%.

Comments

[Ciba Gator:]

Dan, dude, what the heck are you talking about?!?! You can't ignore time value of money "assuming" that one will hold a stock for the next six months and that capital losses in that time will be erased!!!! The central idea with options is that there IS a time value to ownership and capital. Jeez, man, quit it with the inane ramblings, you're just embarrassing yourself.

Of course Satyam looks great in your "analysis". You used a high strike price and ignored all the other variables!! Here's another look at your "analysis"--

Stock price on June-25 $24.50
Call premium for $25 for Jan-08 = $2.60

2007 Jun 26 01:34 PM

[Ciba Gator:]

Sorry, not sure why the original post was truncated. Here's another try:

Dan, dude, what the heck are you talking about?!?! You can't ignore time value of money "assuming" that one will hold a stock for the next six months and that capital losses in that time will be erased!!!! The central idea with options is that there IS a time value to ownership and capital. Jeez, man, quit it with the inane ramblings, you're just embarrassing yourself.

Of course Satyam looks great in your "analysis". You used a high strike price and ignored all the other variables!! Here's another look at your "analysis"--

Stock price on June-25 $24.50
Call premium for $25 for Jan-08 = $2.60
If one buys 200 shares one would invest $4,900
Max return is ($2.60 * 200) + (($25 - $24.50) * 200) = $620 = 12.7%
Min return is $2.60*200 = $520 = 10.6%

THE ACTUAL MIN RETURN IS:
-4,900 + ($2.60 * 200) = -$4,380 IF THE STOCK GOES TO $0.00

Dan, you can't IGNORE the value of the underlying stock. You can't ignore time value of money--of course if you pick a $30 strike price you will make "more money" at the "max". If you had run the analysis with a strike price of $50, you would have calculated an even greater "max" return.

This is beyond sloppy, it's just ignorant. Please try to understand what you are saying befor you say it.

2007 Jun 26 01:41 PM

[Dayanand Me...:]

Hi Ciba,
Please read the title of my blog again "Which IT Outsourcing Company Gives Maximum Return on Covered Calls?"


Also I have mentioned "For calculating maximum return, I have considered the next higher call price than that of the stock price. For example, the next higher call price for INFY, whose stock is around $50.50, is $55."

This is the reason I had to choose the $30.00 strike price for Satyam and I have been consistent with that rule for all other stocks.

I would appreciate if you be professional in your comments.
Thanks,
Dan.

2007 Jun 26 01:50 PM

[Ciba Gator:]

The next higher strike price for Satyam is $25 if the stock is at $24.50. Am I missing something?

2007 Jun 26 02:07 PM

[Dayanand Me...:]

As the difference was just $0.50 so I ignored that and took the next higher price that was $30.00 . The reason I did is because I dont think it is practical to write a covered call on a stock trading at $24.50 for a strike price of $25.00. Unless and until you are just happy with the premoim you get on writing the covered call.

2007 Jun 26 02:56 PM

[Deepak Shenoy:]

Why not simply write a naked put on Infy, Jan 08, strike price 47.5 - you get $3 per share in premium = $300, and your break even is $45. If the stock moves up you can square off (price will be lower) and write a higher put, say $50. It requires far lower investment (just the margin, which is obviously lower than 100 shares x market price) and the pay off diagram is EXACTLY the same as a covered call. Same risk, lower investment, same $ returns = higher return percentages.

2007 Jun 27 01:43 PM

[Dayanand Me...:]

Covered calls are usually written when the amount of risk you want take is limited. For naked put or call there is a great amount of chance you can loose all your money.

SCENARIO : If my investment budget is $20,000 then this is what I would do:

1. Put $15,000 in a stock (and write a covered call) that :
i)I know the most about
ii)Its fundamentals are strong and its income is growing at least 20% per year.
iii)Its market cap is at least $5bn

2. $3,000 in a large cap company that pays good dividend.

3. $1,000 in some small cap stock where I am prepared to loose about 50%.

4.Put the rest $1,000 in a naked put or call where I am ready to loose all

2007 Jun 27 05:19 PM

[Deepak Shenoy:]

Perhaps you misunderstood - i talk about WRITING naked puts, not buying them.

Writing a Naked Put is exactly the same on the risk/return graph as a covered call, if you intend to square off at expiry. It's just that a covered call involves more commissions to the brokers, which is why it has always been promoted. If you plot the pay off diagram a naked put it's exactly the same as a covered call (premium as profit if the stock goes up, strike price minus premium is your break even.

When you write covered calls or naked puts, you should write them on stocks that you do not expect to move much. There are perhaps better stocks than Infy (and indeed the Indian IT pack) to use this strategy.

For the same $20,000 use $15,000 as margin and write a naked put instead. As I said, the payoff is exactly the same as a covered call, and you pay lower commissions. Even if you use the same amount at risk, writing a put is less time consuming since you need to track only one thing (the market price of the put).

2007 Jun 29 09:11 AM

[Dayanand Me...:]

I guess I am getting your point......let me give an example and make sure if this is what you meant.

1. Looking at the put prices for INFY today for Jan-08 strike price of $55, it is $6.50
finance.yahoo.com/q/op...;m=2008-01

2. If I write naked put for 300 shares then I get $1,950 directly.

3. Before Jan-18,2008 I should be ready to buy 300 shares for $55.00 .

MAXIMUM PROFIT : $1,950 by zero investment (ignoring commission costs). This would happen if the share price of INFY remains above $55 for most of the time.

MAXIMUM LOSS : Theorotically I can loose ($16,500 - $1,950) = $14,450. This is if INFY would got to ZERO....:). Which I am pretty sure would not happen.

So practically I might loose some money if INFY let us say goes down to $45.00 by Jan-2008, but there would be a chance to recoup that money if INFY goes up to $48.50 ($55 - $6.5)

Sounds interesting PAL.....do you know if any online broker gives this option.I use Sharebuilder and I dont think they give this option....

2007 Jun 30 12:33 AM

[Deepak Shenoy:]

Actually, you would write an OTM (out of the money) naked put - not an in the money one. $55 put is already in the money to the tune of $4, and the real price of it should be around $9 ($6.5 looks suspiciously low)

For the covered call, you chose a $55 call, getting $3.5 on it. THat means at a spot (cash) price of $50.5, you are effectively getting the share for $47, which is your break even point on the downside. To get the same thing you should write a $50 put for $4 (meaning a BEP of $46) or a $47.5 put at $2.85, which is an (even lower) break even point of $45 or so. THe former is preferable if you are bullish since you get more commissions (which is the income) and the latter is a play-it-safe strategy. Essentially the put should be out of the money and the break even point should be around the same level as the covered call you would otherwise have written.

Coming to brokers that give this option: I am in India where all brokers allow you to write naked puts on Indian stocks or futures, margin requirements vary from 50% to 10% of (strikeprice x lot size). In the US many brokerages do not allow naked put selling - or if they do they ask you to put up 100% of (strikeprice x lot size). the 100% margin is lousy because then it increases your capital exposure needlessly; obviously you will plan to get out of the trade if it goes against you (same as with a covered call). Still it lets you pay brokerage only one way (for the option) which is cheaper than the covered call (buy trade plus the option). But there might be a few that allow a naked put option for a decent margin - you may have to check...

2007 Jul 02 09:15 AM