The stock of SBI has failed to breach the level of Rs.315 over the past 1 year despite repeated attempts. With the pressure of NPAs building up, Pankaj Shah believes that SBI is unlikely to breach this level on the upside in the next 1 year. But, Pankaj has a practical problem. He had purchased 3000 shares of SBI last month at Rs.290. The stock is currently quoting at Rs.280 and Pankaj is willing to hold on to the stock for the next 1 year. He is quite confident that over the next 1 year favourable government policy will enable the stock to cross the 320 levels. So what best can he do in the next 6 months with his SBI holdings? Since he is not expecting the stock to go above its peak level of Rs.315, he can structure a covered call on SBI. At the beginning of each month he will sell the 310 Call of SBI with the hope that the option will expire and he will be able to earn the entire premium.

The table below captures how the Covered call will pan out in the next 6 months…

Spot price of SBI

Call Option Sold

Premium Earned

Premium covered

Net Profit

285

310 Strike

Rs.2.65

2.95

Rs.(0.30)

280

310 Strike

Rs.2.35

0.00

Rs.2.35

277

310 Strike

Rs.2.45

0.25

Rs.2.20

291

310 Strike

Rs.3.30

0.35

Rs.2.95

288

310 Strike

Rs.3.10

1.50

Rs.1.60

299

310 Strike

Rs.4.15

0.00

Rs.4.15

As the table suggests, Pankaj has been selling 310 strike call options at the beginning of each month. Depending on the price movement he has either let the option expire worthless or has squared off 310 strike call option sold. Out of the 6 months during which he sold the options, these options expired worthless in 3 months. During two of the months he had to cover his short option position by buying it back at a smaller profit. In the first month he booked a small loss due to the volatility in the stock.

What happens in the end? Pankaj effectively ends the 6 month period with a net profit of Rs.12.95 by selling the options. For the sake of simplicity we have avoided imputing the brokerage and STT on options, but that is unlikely to substantially change the equation. That means his cost of acquisition for SBI has actually come down to Rs.277.05 (290-12.95). So, instead of idly sitting on the stock, Rajesh has reduced his cost of acquisition of SBI from Rs.290 to Rs.277.05 in the intervening 6 months. This will also enhance the profit and ROI for Pankaj and this strategy can be applied by any trader. Of course, be very clear that the downside is temporary because if the stock is going into a sustained downside then your very logic of holding on to the stock needs to be reviewed. However, what the strategy does is to reduce your cost of holding on to the stock and idling funds.