InvestorQ : What would happen to a covered call in two extreme scenarios of price movement?
Mary Joseph made post

What would happen to a covered call in two extreme scenarios of price movement?

user profile image
sara Kunju answered.
2 years ago

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?

If there is a very sharp fall in the price of SBI, then the equation may not really work in favour of Pankaj. The entire equation works only because there is the assumption that the stock price of SBI will not crack too sharply. If the stock falls below Rs.250, then his MTM loss on the cash market position will be too high and the option selling will not be able to compensate for that.

On the other hand, what happens if the stock of SBI shoots up to Rs.330. Of course, you will start losing money on your options beyond Rs.310, but you have nothing to worry as you are still holding on to your cash market position. It is very important to remember that you must not book profits on your cash market position and leave your short call option naked. Then losses can be unlimited and defeats the entire purpose of the covered call. A Covered is a covered and must only be closed as a joint strategy not in parts and bits.