Portfolio Hedging: Covered Calls & Collars

Plain words first. A call option gives its buyer the right, not the duty, to buy shares at a fixed price (the strike) on or before the expiry date. When you sell a call, you receive the premium today and you take the duty: if the buyer uses the right, you must sell your shares at the strike.

Illustration. You own a share bought at ₹1,000. You sell a 1,050 call for ₹20. Your net cost becomes 1,000 − 20 = ₹980 per share. If the stock ends below 1,050, the call expires worthless and you keep the ₹20. If the stock ends above 1,050, you sell at 1,050. Your gain is capped at (1,050 − 1,000) + 20 = ₹70 per share, however high the stock goes.

The breakeven is ₹980. Above it you are in profit at expiry, below it you are at a loss. If the stock falls sharply, the ₹20 softens the fall only a little. The loss is nearly as large as for an owner who never sold the call. In the worst case, if the stock went to zero, the loss would be ₹980 per share.

What the covered call gives: a small, known income while the stock stays flat or rises mildly. What it takes: all gains above the strike, and it does almost nothing against a large fall. A stock that rises quickly is a case where the covered call trader watches the gains go to the buyer.

A put option gives its buyer the right to sell shares at a fixed price. It works like an insurance policy on your shares: if the price falls below the strike, the put pays the difference. You pay a premium for that cover, whether or not you ever need it.

A collar is three things together: you hold the shares, you buy a put below the current price, and you sell a call above it. The call premium you receive pays for part or all of the put. Illustration: the share is at ₹1,000. You buy a 950 put for ₹15 and sell a 1,050 call for ₹20. Net premium is +20 − 15 = ₹5 received. Net cost of the position is 1,000 + 15 − 20 = ₹995.

Now the outcomes. Below 950 the put pays you point for point, so the most you can lose is 995 − 950 = ₹45 per share. Above 1,050 the call caps your gain at 1,050 − 995 = ₹55 per share. Between 950 and 1,050 the result moves with the stock. The breakeven is ₹995.

This is often called a “zero-cost” or low-cost collar, but be careful with that name. The premiums may net to near zero, yet the cost is real: you have given up every rupee of gain above 1,050. You have also accepted that the put expires, and protection must be bought again for the next period at whatever price the market then charges.

The covered call works best, in terms of outcome, when the stock finishes flat or slightly up. It disappoints when the stock rises fast, because you have promised your shares at a fixed price. It also disappoints when the stock falls a lot, because the premium is a small cushion.

The collar works best when the stock falls, because the put limits the loss. It disappoints in a steady rise, because gains stop at the call strike, and in a flat market, because you may pay renewal costs and receive nothing for them.

What this does not tell you: neither structure predicts where a stock will go, and neither is a source of guaranteed income. If you sell a call on a stock you want to keep for the long term, remember that delivery at expiry means you lose the shares at the strike. Some investors are comfortable with that. Others are not. Know which one you are before selling.