Some of you, on reading the title must be wondering – Rohit is again on his options trip ! this dude is going to get kicked big time, one of these days 🙂

Well, in the spirit of learning and experimenting lets look at an options strategy, that I think marries the value investing approach with options quite well.

What are covered calls?
You can read about call options here. Selling covered calls mean selling a call option in the market while holding the underlying stock. Selling a call option without holding the underlying stock is naked selling (no its not selling without wearing your clothes :), but you could lose them if the naked selling bet goes wrong).

How does it work with value investing ?
The logic is as follows – Suppose you hold a stock which is a mid to long term holding. Lets say you bought the stock for 60 Rs and think the fair value is 100. Now let’s assume that the stock is selling for 95 and you plan to start exiting at 100-105 as you really do not want to hold above fair value. In such as case, one can sell a call on the stock for a strike price above the current quote, say around 110-115.

If the stock continues to climb, the call will get exercised and you will get the 110 exercise price + the premium amount. If the stock drops back and if you had planned to hold on to the stock for the long term as long as the price was below fair value and the fundamentals are good, then you pocket the premium and continue holding the stock.

An example
Lets take the example of a favorite of mine – Infosys technologies. My own estimates of fair value for the stock are around 2700-3000. The stock is currently selling for around 2700 which is close to fair value.

The first option for me is to sell the stock once the price crosses 2700 and be done with it. The other option is to start selling covered calls with a strike price of 3000 or higher. If the stock keeps rising and the call gets exercised, then I will end up exiting at 3000 + premium as planned. On the contrary if the stock drops from here, I can pocket the premium for free. The flip slide is that I will lose money on the stock as it drops.

The risks
If someone ever tells you that there is no risk in an investing strategy, ask him what he is smoking or drinking.

There are several risks in the above plan and it works only for a very specific situation. I would sell a covered call on a stock which I think is selling close to fair value and I would not mind holding it if it dropped below this price – the second part of the statement being the key. As a corollary, the reason I would not mind holding if the price dropped is because I think the company will continue to do well and will increase its intrinsic value at a good rate.

A valid question would be – why not sell and move on? . One reason for trying this approach is plain experimentation – with limited amounts of the stock. The second reason is that I would continue to hold on to the stock for the long term as the company is still doing fine and selling covered calls increases my returns. At the same time if the stock gets too overvalued, I would exit it by selling via the covered call.

If you do not want to hold the stock for the long term and would regret holding it if the price drops, then one should just sell the stock and move on. In summary this is a strategy of trying to be a bit too clever and squeezing out a few percentage points of returns.

As an aside which options should one sell in this case – I would prefer to sell the ones with the longest duration (May 2010 exercise) as I would also benefit from the time decay

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