Covered call

You own a share and intend to keep it for a while. It pays a dividend perhaps once a year and otherwise does nothing for you.

A covered call puts it to work. Sell a call option against the shares you hold. You collect the premium immediately, which reduces your effective cost of acquisition. In return, you have promised to deliver those shares at the strike if the buyer wants them — so any rise above the strike is no longer yours.

The word covered is the whole point. A naked short call has an unlimited loss, because the writer must buy shares at any price to deliver them. Here he already owns them, so the obligation is already met. The risk that is left is not the option's; it is the risk of owning the share.

The combined payoff is the part the exam cares about. Long stock plus short call produces a chart that rises to a cap and then goes flat, with losses continuing all the way down — which is the payoff of a short put. The workbook names it: the covered call is a "synthetic short put".

That identity is not a curiosity; it is an arbitrage relation. If the actual put at the same strike trades away from the price the covered call implies, a risk-free profit exists. The workbook's own illustration: a covered call implying Rs 20 while the 1,600-strike put trades at Rs 17 leaves a Rs 3 risk-free profit, before brokerage, taxes, administrative costs and funding — which it is careful to say must be provided for.

Choosing the strike is the real decision, and the workbook frames it as a trade:

• A strike near the spot fetches a fat premium but locks in the gain almost immediately.
• A strike far above the spot fetches little but leaves room for the share to run.

Its practical rule: as long as the share is below your pre-decided exit price, keep writing calls at that exit strike and keep the premium. When the spot reaches it, sell in the cash market and cover the short call together.

Add a long out-of-the-money put and the position becomes a collar — the floor the covered call does not have.

Covered call = Long underlying + Short call
             ≡ Short put at the same strike     (synthetic short put)

BEP        = Purchase price of the stock − Premium received
Max profit = (Strike − Purchase price) + Premium received
Max loss   = Purchase price − Premium received      (stock falls to zero)

An investor buys the share at Rs 1,590 and writes the 1,600 call for Rs 10. Take a lot size of 550, so he holds 550 shares against one contract.

Cost of shares    = 1,590 × 550 = Rs 8,74,500
Premium received  =    10 × 550 = Rs    5,500
BEP               = 1,590 − 10  = Rs 1,580
Max profit        = (1,600 − 1,590) + 10 = Rs 20 per share = Rs 11,000

Above 1,600 the line goes flat forever. At 1,690 the shareholder who wrote nothing has Rs 55,000; the covered call writer has Rs 11,000. The Rs 5,500 he collected cost him Rs 44,000 of upside.

And below? At 1,490 the unhedged holder is down Rs 55,000; the covered call writer is down Rs 49,500. The premium absorbed 10 points of a 100-point fall.

Downside cushion = Rs 10 of Rs 1,590 = 0.63% of the position

That is the honest measure of a covered call: it is an income strategy, not a hedge. It gives up an unlimited upside for a 0.63% buffer. Which is precisely why the payoff is that of a short put — and why adding a Rs 7 put at 1,580 to make a collar caps the loss at Rs 7 a share while trimming the best case from Rs 20 to Rs 13.

Chapter 17.2 works the covered call with the 1,590/1,600/Rs 10 numbers above, names it a synthetic short put, and gives the Rs 3 arbitrage illustration. The Chapter 17 sample questions ask which of a list is a hedged position, with covered call and protective put both among the options — read the question carefully, because the covered call hedges the option, not the shareholding.

• A covered call is not downside protection. The premium is a small cushion; the stock can still fall to zero. For a floor you need a protective-put or a collar.
• Its payoff is a short put, not a long call. The workbook says so explicitly — and a protective-put is the synthetic long call. The two identities are easy to swap.
• The maximum profit is capped at the strike, no matter how far the share runs.
• Break-even is the purchase price minus the premium, not the strike.
• "Covered" refers to the shares held, not to safety. It means the writer can deliver, nothing more.
• The arbitrage is only theoretical until costs are counted. The workbook is explicit that brokerage, taxes, administrative costs and funding must be provided for.