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Hedging Strategy - Covered Call
Earlier, we learned that there are two types of hedging strategies, namely ‘Covered Call’ and ‘Protective Put.’ Let us now discuss them in detail, starting off with the 'Covered Call' in unit. But before that, we must understand what exactly is 'Hedging?'
Hedging is a technique that is frequently used by many investors and options traders. The basic principle of hedging is that it is used to reduce or eliminate the risk of holding one particular investment position by taking another position.
Hedging doesn’t help the trader or an investor to make money. It helps them to protect themselves from a probable loss. The versatile nature of options make them useful when it comes to hedging.
Many investors that don’t usually trade options use them to hedge against existing investment portfolios of stock. There are few options trading strategies that can specifically be used for this purpose, such as covered calls and protective puts.
What is a 'Covered Call' ?
A covered call is an options strategywhereby an investor holds a long position in a stock either in Cash or Futures and sells call options on that same stock in an attempt to generate increased income from the asset or to protect downside to a certain extent.
This is often employed when an investor has a short-term neutral view on the stock and for this reason holds the stock long and simultaneously has a short position via the option to generate income from the option premium.
It serves as a short-term small hedge on a long stock position and allows investors to earn premium, hence reducing costs.
Strategy Involves:
1.Buy Stock ( futures or Cash )
2.Sell 1 Call Option
The breakeven point of the strategy will be Current stock price minus the premium received for selling the call.
Maximum Profit is limited, strike price minus the current stock price plus the premium received for selling the call.
And what is the maximum loss? The trader receives a premium for selling the option, but most downside risk comes from owning the stock, which may potentially lose its value, if the asset goes down. In fact, selling the option creates an “opportunity risk.” i.e. if the stock price skyrockets, the calls might be assigned and the trader will miss out on those gains. As a call is sold at a higher strike price the loss from call sold will be offset by stock as the price rises.
A covered call can enable you to profit in a sideways market; take advantage of an anticipated decline in volatility. If you already own stock, and volatility in the market rises dramatically, you may want to consider selling a covered call because the option premium may be attractive and you can profit from a decline in volatility (theta). If implied volatility declines after the call is sold, assuming that all other factors remain constant, a call option will decrease in value.
