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 (NASDAQ: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:
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% .
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%
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%
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%
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%.