The Covered Call: Selling Upside Against a Holding

A covered call is one unit of the reference asset held with one call written against it at one level. Everything the unit does below that level stays with the holder, and everything it would have done above the level now belongs to somebody else, in exchange for a premium taken in on day one. At the end date the pair pays the price of the reference asset or the level, whichever is smaller.

A covered call is that and nothing more, and the rule about the end date does the work. Writing a call obliges the writer to perform whenever the other side decides to ask. Holding the unit is what makes that obligation performable out of something already sitting there rather than out of something that has to be gone and found on the day. Nothing about holding the unit makes the obligation smaller. Holding the unit changes where the performance comes from, and it changes what remains with the writer if the price runs past the level.

What is a covered call once its two parts are written out?

Earlier in this sequence a way of writing any arrangement down was established: each contract becomes one row, and the row carries a sign, a kind, a level and an end date. Two rows is all this one needs. The first row is plus one unit of the reference asset, held. The second row is minus one call at Rs 2,000.00/-, running for one year.

The first of those two rows is not a contract at all, and the notation has to stretch to hold it. Every row written so far has been an option, so every row has carried a level and an end date. A held unit carries neither. A held unit does not expire, and there is no level at which it starts or stops doing anything. The unit simply sits there being worth whatever it is worth. So it goes into the rows with a sign and a quantity and two empty cells, and the emptiness is not a gap in the record. The emptiness is what a held thing looks like written beside a contract.

Here is the everyday version, and it is worth holding on to because it survives every complication that follows. A shopkeeper has a crate of goods in the back of the shop, bought and paid for. A neighbour comes in and pays the shopkeeper a small sum for the right to buy that crate at a fixed figure, any time this season. The crate does not move. The crate stays in the shop, it still belongs to the shopkeeper, and if nobody comes for it the shopkeeper still has it. The crate did not change hands. The decision about where the crate goes, once it is worth more than the fixed figure, is what changed hands.

Notice what the shopkeeper did not do. The shopkeeper did not borrow the crate, did not promise to find a crate, and did not agree to anything that requires going out and buying one at whatever the going rate turns out to be. The word covered means exactly that. The performance, if it is ever called for, comes out of stock already on the premises.

Now the working figures. The reference asset in this material has a spot price of Rs 2,000.00/-. Money costs 6.50 per cent across the twelve months under consideration, and the call written here runs to the end of those same twelve months. Held for the whole year, this unit pays nothing out on the way. A payment arriving mid-year would move every figure that follows. The call at this level is carried at Rs 180.00/-, a figure that sits in the working record and is never computed here.

Two Rs 2,000.00/- figures sit in this guide and they are not one quantity copied twice. One of them is what the unit cost to buy. The other is the level the call was written at. Both premiums were struck level with the price on the day, so the two figures agree. Being struck at the money amounts to exactly that. Where a spot and a level coincide and nobody says why, the silence is a warning rather than tidiness.

How Covered Calls Change the Rights and Obligations Around a Share Position: what is different the day after the call is written?

The day after the call is written is where most of the confusion about a covered call lives. Take the day before. The unit is held outright. Every right that comes attached to it belongs to the holder, who may sell it this afternoon or in eleven years. Nobody else has a say in what happens to it at any price whatsoever, and whatever it does in either direction lands on the holder and on nobody else.

Now write the call. Three things are different the next morning, and the middle one is the one that gets skipped.

The first is that the unit is still held. Ownership did not move an inch. Every rupee it loses on the way down is still carried by the holder, all the way to a price of Rs 0.00/- if it should get there, and the written call does nothing whatever about that. The premium is a fixed amount. Anyone who says the arrangement cushions a fall is calling that fixed amount a cushion, and it is not one.

The second is that a right has been sold, and it is worth naming exactly which one. The right sold is the right to take the unit away from the holder at Rs 2,000.00/-. Above that level the decision about where the unit goes is no longer the holder's to make. Somebody else makes it, at a moment of their choosing, and the holder finds out afterwards.

The third follows from the second and is the one that shows up as friction rather than as arithmetic. The writer is now obliged to perform when asked. The unit is no longer freely disposable in the way it was the day before, and selling it in the ordinary course with a written call standing against it is not the same act it used to be. Ownership did not move; the decision above the level did, and with it the freedom to do as the holder pleases with a thing still owned.

Two things around this arrangement are settled by the regulator, and they sit close enough to the mechanism that leaving them unmarked would be misleading. Whether a unit already held may be handed over against a written call, and under what terms, is one. The other is the amount that must be lodged behind a written leg while a unit is held beside it. Both are drawn out in full further down, in a block of rows with the authority printed inside each row and the value column left blank.

What does the pair pay at the end date, and where does that stop?

Worked at any price at all, the two rows give the answer without any cleverness. Take a price below the level first, say Rs 1,600.00/-. The unit is worth Rs 1,600.00/-. The written call is silent. Nobody exercises a right to buy at Rs 2,000.00/- something they could have for Rs 1,600.00/-. So the pair pays Rs 1,600.00/-, exactly what the unit on its own would have paid.

Now take a price at or above the level, say Rs 2,400.00/-. The unit is worth Rs 2,400.00/-. The written call now owes the price less Rs 2,000.00/-, or Rs 400.00/-. Set the two against each other and the pair pays Rs 2,000.00/-. Now run the price up to Rs 2,600.00/-: the unit stands at Rs 2,600.00/-, the written call owes Rs 600.00/-, and once more Rs 2,000.00/- is what comes out. The pair pays the price of the reference asset or Rs 2,000.00/-, whichever is smaller, and Rs 2,000.00/- is the ceiling on what it pays.

The cancelling above the level is rupee for rupee and it is worth seeing why rather than accepting it. Every rupee the price rises above Rs 2,000.00/- adds one rupee to the unit's value and one rupee to the written call's debt. Two quantities moving at the same speed in opposite directions add to nothing. The cancelling is the whole mechanism of the flat stretch, and it holds at Rs 2,001.00/- exactly as it holds at Rs 20,000.00/-.

One label matters more here than anywhere else. Everything worked out so far is a payoff: the reading that leaves out whatever was paid or received to get the arrangement in place. A covered call has both a payment and a receipt sitting in it, and the unit was paid for while a premium was taken in. Neither has appeared yet. A reader who stops at this block and walks away with the figure Rs 2,000.00/- as what the arrangement earns has read a payoff as though it were a result.

What did the pair cost, and how does the payoff line become a profit line?

Most arrangements in this sequence stop at the payoff. Completing the cost would need a premium at a level the working record does not price. A covered call is the exception: both of its parts sit at the one level that is priced, so the cost arithmetic closes with nothing estimated and nothing guessed. The arrangements either side of it do not share that convenience.

Two amounts move at the start, and they move in opposite directions. The unit is bought for Rs 2,000.00/-, and this is the one place in the sequence where that figure is an amount that actually left somebody rather than a notionalA size a contract is written across, working as a multiplier. Nobody hands that amount over. a contract is written across. Money went out. If it was borrowed it accrues. If it was not borrowed it could have been earning elsewhere, and the two come to the same thing. Carried forward across the year at 6.50 per cent, that Rs 2,000.00/- stands at Rs 2,130.00/- by the end date.

The premium of Rs 180.00/- goes the other way. The premium came in on day one, so it has been sitting there for the same twelve months and is carried by the same arithmetic. Rs 180.00/- taken forward twelve months at 6.50 per cent reaches Rs 191.70/-. Both amounts sat over the same twelve months, so both are moved by the same carryThe financing charge of keeping hold of something from one date through to a later one, quoted as a rate over a period.. Both figures now stand on the end date, and two amounts that moved on different days can be set against each other honestly in no other way.

So the profit is the payoff less Rs 2,130.00/- plus Rs 191.70/-, or the payoff less Rs 1,938.30/-. That single subtraction is the whole of the difference between the two lines. Every profit figure in this guide comes from taking a payoff and removing Rs 1,938.30/- from it. There is no second step and no second adjustment.

Four prices give the whole arrangement in four lines. At Rs 1,600.00/- the pair pays Rs 1,600.00/- and its profit is minus Rs 338.30/-. At Rs 2,000.00/- the pair pays Rs 2,000.00/- and its profit is Rs 61.70/-. At Rs 2,130.00/- what the written call owes comes to Rs 130.00/-, so the pair pays Rs 2,000.00/- and its profit is Rs 61.70/- again. At Rs 2,400.00/- the amount owed on that written leg reaches Rs 400.00/-, the pair still pays Rs 2,000.00/-, and its profit is Rs 61.70/- once more.

The second row of that table is the only price at which this arrangement comes out level, and it is worth a moment on its own. At Rs 1,938.30/- the pair pays Rs 1,938.30/-, the subtraction takes all of it, and the profit is Rs 0.00/-. Set that beside the unit held on its own. The unit alone comes out level at Rs 2,130.00/-, its forward priceA spot price carried across a period at the financing cost. Buying now on borrowed money adds up to exactly that by the later date, and it is never a guess about that date.. The two break-even prices are Rs 191.70/- apart, and that gap is not a coincidence of invented figures. The gap is the premium taken in and carried, sitting exactly where it should be found.

Why is the most this can earn exactly Rs 61.70/-?

At any price at or above the level the pair pays Rs 2,000.00/-, so Rs 1,938.30/- taken off Rs 2,000.00/- leaves Rs 61.70/-. The subtraction is arithmetic, and it checks in a second. The interesting question is not how the figure arises but what the figure already is.

Its put counterpart at the same level sits at Rs 57.93/- in this record. Carry that forward twelve months at 6.50 per cent and it reaches Rs 61.70/-. The ceiling on what this arrangement can earn turns out to be a premium already met, belonging to a contract that appears nowhere in its two rows. The coincidence is not a curiosity, but the relationship between a call and a put at one level, arriving from a direction not taken so far.

Here is the reason, and it needs no algebra. Take the pair and ask what it obliges at every price. Below the level it hands over the price, and above the level it hands over Rs 2,000.00/- and no more. Now take a single written put at the same level and ask the same question. Below the level the writer owes the level less the price, so the position hands over the level less that shortfall, and that comes to the price. Above the level the put is silent and the position hands over nothing at all beyond the level it started from. Two entirely different sets of rows, and the obligation is identical at every price without exception. If the obligations match everywhere, the most either can earn has to match too, and the most a written put can earn is the premium it took in, carried to the end date.

One caution, and it is the same one made earlier in this sequence. The record carries the put at Rs 57.93/-, a figure rounded to the paisa. Carried forward, that rounded figure reaches Rs 61.6954/-, not Rs 61.70/- on the nose. The unrounded put, the one the relationship actually produces, does carry forward to Rs 61.70/- exactly. So the two routes agree to the paisa, and to the paisa is how it is put here, never as an exact equality. An equality stated as exact when the printed figures do not produce one is an invitation to stop checking, and the checking is the skill.

What has been handed over, and at which prices?

Below the level nothing has been handed over at all. At Rs 1,600.00/- the pair pays Rs 1,600.00/- and the unit on its own would also have paid Rs 1,600.00/-. The two are the same figure, and the written call has taken nothing from the holder because it never came into play.

At Rs 2,130.00/- the unit on its own would have paid Rs 2,130.00/- and the pair pays Rs 2,000.00/-. The difference is Rs 130.00/-, and that Rs 130.00/- went to the other side. At Rs 2,400.00/- the unit on its own would have paid Rs 2,400.00/-, the pair pays Rs 2,000.00/-, and Rs 400.00/- has gone across. At Rs 2,600.00/- the figure is Rs 600.00/-.

The right sold here has no ceiling on it: what goes across grows with the price, and nothing anywhere in the arrangement stops it. That is the same sentence written about a bought call under the treatment of ceilings, and here it is arriving from the other side of the same contract. A bought call and a written call are one contract seen from two chairs. If the one can earn without a stop, the other can hand over without a stop.

Set that against the other half of the agreement: a stop is there and always was. The premium taken in is Rs 180.00/- and it is Rs 180.00/- at every price the reference asset can possibly reach. Carried to the end date it is Rs 191.70/-, and that is still the same at every price. One side of this agreement is a fixed length and the other side is a length that grows, and those are not the same kind of quantity at all.

The middle pair in that picture deserves its own sentence. Exactly one end-date price brings the two amounts level, and that price is Rs 2,191.70/-, the level plus the carried premium. Below it the carried premium is the larger of the two. Above it the amount going across is the larger, and it keeps growing. Which side of Rs 2,191.70/- the price lands on is not knowable in advance by anybody, and the arrangement gets entered without knowing it.

A ceiling drawn without a floor beside it is half a picture. The floor deserves stating just as plainly. At a price of Rs 0.00/- the pair pays Rs 0.00/- and the profit is minus Rs 1,938.30/-. Minus Rs 1,938.30/- is the whole of what was paid for the unit, carried forward, less the premium taken in and carried forward. Writing the call did not put a floor under anything. Writing the call moved the break-even price down by Rs 191.70/- and did nothing else on the way down at all.

If the premium is not income, what is it?

Almost every description of this arrangement outside this material calls the Rs 180.00/- income. The Rs 180.00/- is not income, and seeing what it is not comes before seeing what it is. No premium says how likely any price is, so no premium can say what an arrangement will do, and a receipt on day one is not a result. Conservative and safe are the wrong words for it too, for the same reason and not out of caution.

The premium is the price of an obligation. Somebody paid Rs 180.00/- in exchange for the writer's agreement that they, and not the writer, decide what happens to the unit above Rs 2,000.00/-. The money has moved, and it does not come back. Call it a payoff and the label is wrong twice over: a payoff gets measured at the end, and this arrived at the start. The premium is not a profit either. A profit is a payoff with everything paid and received already counted into it, and the premium is one of the things being counted.

Try the test on the shopkeeper again. The neighbour did not hand over money for nothing, and did not hand it over as a gift or a fee for the shopkeeper's trouble. The neighbour bought something specific: the right to take the crate at a fixed figure. The money is what that right cost. Ask what was sold, and if the answer is everything above a level, then the premium is the price of everything above that level. Carried into every premium, that one question stops a premium ever reading as though it arrived from nowhere.

There is a second habit worth building here, and it costs nothing. Every figure in material like this is one of four things, and naming which one takes a moment. Is it a price, meaning what something changes hands at? Is it a premium, meaning what a contract cost to enter? Is it a payoff, meaning what an arrangement hands over at the end before anything else is counted? Or is it a profit, meaning that payoff with the money already moved counted in? Rs 2,000.00/- here is a price in one place and a level in another. Rs 180.00/- is a premium. Rs 2,000.00/- at the end date is a payoff. Rs 61.70/- is a profit. Four figures, four different jobs, and mixing any two of them produces a sentence that sounds fine and is wrong.

Who fills in each of the four rows, and which row has no form to sit on?

Rather than name four kinds of people who might look at this arrangement, look instead at the four rows somebody has to fill in, and ask which sheet each row is printed on. The rows are the more useful question: three of the four have a home and one of them does not.

Look at what that table is really saying. A unit that somebody else can call away at a fixed figure is not the same collateral as one that cannot be, so a lender extending money against it needs the fourth row. An analyst reading a set of accounts that contain written calls needs the fourth row too. The second row and the fourth row together turn a list of premiums received into an obligation. The only row here that arrives by itself is the first one, and it is the smallest of the four.

A household holding one unit and thinking about writing a call against it has the same four rows and a simpler version of the same problem. The Rs 180.00/- will show up in a bank account and feel like something that happened. The Rs 2,000.00/- will not show up anywhere at all after the day the contract is signed. Writing both figures on the same sheet of paper on the same day is the entire discipline, and it takes about a minute.

Should a call be written against a unit already held?

The question cannot be settled from the two rows alone, and what stops it is arithmetic rather than caution. Answering would take a sense of where this price might end up and what weight each ending deserves, and the working record kept for this material carries not one past price. An answer would take the holder's own position too: whether they would still be standing if the price went to Rs 0.00/-, and whether the unit held is even theirs to encumberTo attach somebody else's claim to a thing held, so that it is no longer entirely free to dispose of as the holder pleases.. And it would take the cost of placing the arrangement, keeping it open and unwinding it. Nobody has quoted that cost.

The three differ in where they could have come from. The first is genuinely absent from the record: no run of past prices anywhere in it, no spread of possible endings and no weight attached to any of them. How often the ceiling binds cannot be stated without those three. The second belongs to the holder and could not be anybody else's. The third belongs to whoever the arrangement would be placed through, and an invented figure for it would be worse than leaving it out.

The whole of the obligation is one thing, and a complete description of what agreeing would mean is not a reason to agree to it. The obligation comes in order: the two rows, then what changes around them, then what is paid, then what it costs. Only after all four does the question of whether to write the call make sense, and by then it is plain that answering it takes three things arithmetic cannot supply.