I recently learned that covered call writing comes in all shapes and sizes. Although we are honored to have a significant number of international members, most trade US stocks on US exchanges with the rules we are familiar with. But what if the rules were different? Let’s look at baseball for a minute. What if you “walked” on 3 balls instead of 4 and “struck out” on 2 strikes instead of 3? What if the pitching mound was 3 feet closer to home plate and the bases 5 feet further apart? Maybe we won’t try to steal that base afterall!  It’s still baseball but with different rules that change how the game is played…it’s virtually a foreign game that has to be strategized from a different perspective.

One of our members, Ashwin from India, has been generous enough to share this information with me and now me with you. Ashwin trades Indian stocks on the Indian stock exchange and is a proponent of covered call writing. I found the differences between US and Indian covered call writing fascinating and decided to share this information with you.

Rules for covered call writing in India

• Indian options are 100% cash-settled meaning they can never be exercised (we can never lose the stock)
• If the option ends up in-the-money, the option seller (the covered call writer) must pay the holder in cash. If we sold a $30 call and the price of the stock was $40 at expiration, the seller would have to pay $10 per share to the buyer of the option
• All Indian options are European style as opposed to the American style options we are familiar with. This means that the holder can only receive cash settlement after expiration
• The option contract size of the underlying will vary from stock to stock and not (almost) always be 100 shares. Each year the Indian stock exchange reviews the share prices of all equities traded on the exchange and adjusts the number of shares per contract such that the cost of ownership of the underlying remains affordable. More expensive securities will require less shares per contract. The US exchanges recently addressed this concept with the institution of the “Mini options“
• Because of the cash-settlement requirement, Indian brokerages require investors to set aside 10-20% of the contract size (# shares x stock price) in cash. The amount the brokerage will require depends on the volaility of the underlying, with the most volatile stocks requiring the highest percentages. If the investor has a substantial portfolio, this requirement may be waived as do brokerages in the US

Percentage returns in India

The example Ashwin was kind enough to send me information for Infosys which was trading @ $44.20. The exchange requirement per contract = 125 shares or $5530.00. The near-the-money $44.20 call was generating $1.24. Let’s do the math:

125 x $1.24/ $5530 = 2.8%, 2-week initial return

Let me add this one caveat: INFY has earnings due out prior to expiration so the implied volatility on the option is high but if we extrapolate the returns seem fairly similar to US exchanges and that is also the information provided to me.

Is this a popular strategy in India?

NO!!! Based on feedback Ashwin has received from investors from Indian trading forums the high capital requirements (buying the shares and margin requirement for settlement) discourages many traders.

Advantages (as I see them)

• No one stock will be too expensive to enter a covered call position
• There are no tax concerns relating to selling shares with a low cost basis or impacting holding periods for short versus long-term capital gains
• The covered call writer will never be exercised early causing the holder to capture a dividend instead of the call writer
• A call writer can simply sell a few shares to cover cash settlement and retain the bulk of the shares if so desired
• Options can be rolled to avoid or delay settlement

Disadvantages (as I see them)

• We must be diligent to keep track of the number of underlying securities since this will vary from stock to stock
• Calculations will also require more diligence since the number of underlying varies
• A significant percentage of cash available cannot be put to work since we must make 10-20% available for settlement

Conclusion

Covered call writing is a great strategy for conservative retail investors. Much like baseball, if the rules change, the approach to the strategy must also fluctuate as we have seen in this article. Rules can also change impacting how we approach our investments. It is critical to understand all the parameters that apply so we can take advantage of them and maximize our returns to the highest possible levels.

***Many thanks to Ashwin for sharing this information.

Market forces:

This week we saw several triple digit movements in the markets causing stock prices to move dramatically. This is in line with the belief that over 70% of a stock’s price movement is based on overall market conditions. In the BCI methodology we study the price charts of the S&P 500, the CBOE VIX and weekly economic reports to help craft our covered call writing positions. Below is a price chart for AMGN, one of the stroger equities on our current Premium Stock List. Note how the chart remains strong but has defintely been impacted by the recent market volatility. The chart was taken after market close on Wednesday:

Market forces impacting stock price

Market tone:

In a week of emotional domestic and political events, the economic reports seem almost second nature. However, as news of the second terrorists’ capture is being announced, I present this week’s summary:

• The cost of consumer goods declined by 0.2% in March
• Core CPI (excludes food and energy) was up 1.9% in March. The Fed’s monetary policy appears NOT to be causing inflationary concerns
• Construction of multi-family homes caused housing starts to increase by 7% in March, the highest level since June, 2008
• The number of new building permits fell by 4% in March however home-related spending has added to economic growth for 7 straight quarters
• Industrial output rose by 0.4% in March, the largest monthly increase since early 2007
• The Federal Reserve Beige Book showed that new home construction and auto manufacturing has assisted the US economy to grow moderately through early April
• The Conference Board’s index of leading economic indicators dropped by 0.1% in March, down from an average 0.5% increase over the past 3 months

For the week, the S&P 500 fell by 2.1% for a year-to-date return of 9.7%

Summary:

IBD: Market in correction

BCI: Cautiously bullish favoring in-the-money strikes 3-to-2

With special thoughts to our friends and family in Boston and West, Texas,

Alan and the BCI team (alan@thebluecollarinvestor.com)

www.thebluecollarinvestor.com