17.1.2.1 Interim Cash Flows

In deriving the basic pricing model in Chapter 16, it was assumed that no interim cash flows arise because of changes in futures prices (that is, there is no variation margin). For a stock index, there are interim cash flows. In fact, there are many cash flows that happen at the dividend dates of the companies comprising the index. To price a stock index future contract correctly, it is necessary to incorporate the interim dividend payments. However, the dividend rate and the pattern of dividend payments are not known with certainty. Consequently, they must be projected from the historical dividend payments of the companies in the index. Once the dividend payments are projected, they can be incorporated into the pricing model.

An additional consideration is that the value of the dividend payments at the settlement date will depend on the interest rate at which the dividend payments can be reinvested from the time they are projected to be received until the settlement date. The lower the dividend and the closer the dividend payments to the settlement date of the futures contract, the less important the reinvestment income is in determining the futures price.

17.1.2.2 Differences in Borrowing and Lending Rates

In the derivation of the theoretical futures price in equation (17.1), it is assumed in the cash-and-carry trade and the reverse cash-and-carry trade that the borrowing rate and lending rate are equal. In real-world financial markets, however, the borrowing rate is higher than the lending rate. The impact of this inequality in rates is important and easy to quantify.

In the cash-and-carry trade, the theoretical futures price as given by equation (17.1) becomes

17.2

For the reverse cash-and-carry trade, it becomes

17.3

Equations (17.2) and (17.3) together provide a band within which the actual futures price can exist without allowing for an arbitrage profit. Equation (17.2) establishes the upper value for the band while equation (17.3) provides the lower value for the band. For example, assume that the borrowing rate is per year, or for three months, while the lending rate is per year, or for three months. Using equation (17.2), the upper value for the theoretical futures price is , and using equation (17.3), the lower value for the theoretical futures price is .

17.1.2.3 Transaction Costs

The two strategies to exploit any price discrepancies between the cash market and theoretical futures price will involve the incurrence of transaction costs—the costs of entering into and closing the cash position as well as round-trip transaction costs for the futures contract. These transaction costs will cause a discrepancy between the theoretical futures price given by equation (17.1) and the actual futures price in the market. As in the case of differential borrowing and lending rates, transaction costs widen the band for the theoretical futures price.

17.1.2.4 Short-Selling Restrictions

The reverse cash-and-strategy trade requires the short selling of the underlying. It is assumed in this strategy that the proceeds from the short sale are received and reinvested. In practice, for individual investors, the proceeds are not received, and in fact the individual investor is required to deposit margin (securities margin and not futures margin) to short sell. For institutional investors, the underlying may be borrowed, but there is a cost to borrowing. This cost of borrowing can be incorporated into the model by reducing the cash yield on the underlying. For strategies applied to stock index futures, a short sale of the stocks comprising the index means that all stocks in the index must be sold simultaneously. This may be difficult to do and therefore would widen the band for the theoretical futures price.

17.1.2.5 Deliverable Is a Basket of Securities

The problem in arbitraging stock index futures contracts is that it may be too expensive to buy or sell every stock included in the stock index. Instead, a portfolio containing a smaller number of stocks may be constructed to track the index with the goal of having price movements that are very similar to changes in the stock index. Once the cash-and-carry and the reverse cash-and-carry strategies involve a tracking portfolio rather than a single asset for the underlying, however, the strategies are no longer riskless because of the risk that the tracking portfolio will not replicate the performance of the stock index exactly. For this reason, the market price of stock index futures contracts is likely to diverge from the theoretical futures price and have wider bounds (i.e., lower and upper theoretical futures prices) that cannot be exploited.

17.1.3.1 Controlling the Risk of a Stock Portfolio

As explained in Chapter 9, beta is a measure of the sensitivity of a portfolio to movements in the market. A portfolio manager who wishes to alter exposure to the stock market or a sector of the stock market can do so by rebalancing so that a portfolio's current beta will equal a targeted portfolio beta. In doing so, the portfolio manager will incur transaction costs. Because of the leverage inherent in futures contracts, portfolio managers can use stock index futures to obtain a target beta for the portfolio at a considerably lower cost. Buying stock index futures will increase a portfolio's beta, and selling them will reduce it.

17.1.3.2 Hedging against Adverse Stock Price Movements

Hedging involves the use of futures contracts as a substitute for a transaction to be made in the cash market. If the cash and futures markets move together, any loss realized by a portfolio manager seeking to a hedge on one position (whether cash or futures) will be offset by a profit on the other position. When the profit and loss are equal, the hedge is called a perfect hedge.

A short hedge is used to protect against a decline in the future cash price of the underlying. To execute a short hedge, the portfolio manager sells a futures contract. Consequently, a short hedge is also referred to as a sell hedge. By establishing a short hedge, the portfolio manager has fixed the future cash price and transferred the price risk of ownership to the party who has purchased the futures contract.

As an example of a portfolio manager who would use a short hedge, consider a pension fund manager who knows that the beneficiaries of the fund must be paid a total of $30 million four months from now. This will necessitate liquidating a portion of the fund's common stock portfolio. If the value of the shares that the portfolio manager intends to liquidate in order to satisfy the payments to be made decline in value four months from now, a larger portion of the portfolio will have to be liquidated. The easiest way to handle this situation is for the portfolio manager to sell the needed amount of stocks and invest the proceeds in a U.S. Treasury bill that matures in four months. However, suppose that for some reason, the portfolio manager is constrained from making the sale today. The portfolio manager can use a short hedge to lock in the value of the stocks that will be liquidated.

A long hedge is undertaken to protect against rising prices of future intended purchases. In a long hedge, the hedger buys a futures contract, so this hedge is also referred to as a buy hedge. As an example, consider once again a pension fund manager. This time, suppose that the portfolio manager is confident that there will be a substantial contribution from the plan sponsor four months from now, and that the contributions are targeted to be invested in common stock of various companies. The pension fund manager expects the market price of the stocks in which she will invest the contributions to be higher in four months and, therefore, takes the risk that she will have to pay a higher price for the stocks. The portfolio manager can use a long hedge to lock in effectively a future price for these stocks now.

Hedging is a special case of controlling a stock portfolio's exposure to adverse price changes. In a hedge, the objective is to alter a current or anticipated stock portfolio position so that its beta is zero. A portfolio with a beta of zero should generate a risk-free interest rate. This is consistent with asset pricing models. Thus, in a perfect hedge, the return will be equal to the risk-free interest rate. More specifically, it will be the risk-free interest rate corresponding to a maturity equal to the number of days until the settlement of the futures contract.

Therefore, a portfolio that is identical to the S&P 500 (i.e., an S&P 500 index fund) is fully hedged by selling an S&P 500 futures contract with 60 days to settlement that is priced at its theoretical futures price. The return on this hedged position will be the 60-day, risk-free return. Notice what has been done. If a portfolio manager wanted to eliminate temporarily all exposure to the S&P 500, the portfolio manager could sell all the stocks in the portfolio and, with the funds received, invest in a Treasury bill. By using a stock index futures contract, the portfolio manager can eliminate exposure to the S&P 500 by hedging, and the hedged position will earn the same return as that on a Treasury bill. The portfolio manager thereby saves on the transaction costs associated with selling a stock portfolio. Moreover, when the portfolio manager wants to get back into the stock market, rather than having to incur the transaction costs associated with buying stocks, she simply removes the hedge by buying an identical number of stock index futures contracts.

In practice, hedging is not a simple exercise. When hedging with stock index futures, a perfect hedge can be obtained only if the return on the portfolio being hedged is identical to the return on the futures contract. The effectiveness of a hedged stock portfolio is determined by (1) the relationship between the cash portfolio and the index underlying the futures contract and (2) the relationship between the cash price and futures price when a hedge is placed and when it is lifted (liquidated).

The difference between the cash price and the futures price is called the basis. It is only at the settlement that the basis is known with certainty. At the settlement date, the basis is zero. If a hedge is lifted at the settlement date, the basis is therefore known. However, if the hedge is lifted at any other time, the basis is not known in advance. The uncertainty about the basis at the time a hedge is to be lifted is called basis risk. Consequently, hedging involves the substitution of basis risk for price risk.

A stock index futures contract has a stock index as its underlying. Since a portfolio that a manager seeks to hedge will typically have different characteristics from the underlying stock index, there will be a difference in the return pattern of the portfolio being hedged and the futures contract. This practice—hedging with a futures contract that is different from the underlying being hedged—is called cross hedging. In hedging a stock portfolio, a manager must choose the stock index, or the combination of stock indexes, which best (but imperfectly) track the stock portfolio.

Consequently, cross-hedging adds another dimension to basis risk because the portfolio does not track the return on the stock index perfectly. Mispricing of a stock index futures contract is a major portion of basis risk and is largely random. The previous points about hedging can be made clearer with the following illustration, which also provides a blueprint for how hedging is implemented by a portfolio manager.

To implement a hedging strategy, it is necessary to determine not only which stock index futures contract to use, but also in how many of the contracts to take a position (i.e., how many to sell in a short hedge and buy in a long hedge). The number of contracts depends on the relative return volatility of the portfolio to be hedged and the return volatility of the futures contract. The hedge ratio is the ratio of volatility of the portfolio to be hedged and the return volatility of the futures contract.

It can be shown that the hedge ratio can be found by multiplying (1) the beta of the portfolio relative to the underlying stock index for the futures contract and (2) the beta of the stock index for the futures contract relative to the stock index futures contract.² The two betas are estimated using regression analysis, the statistical tool described in Chapter 4.2, using historical returns. Specifically, the first regression to be estimated to obtain the beta of the stock portfolio relative to the stock index is

17.4

where

	=	beta (sensitivity) of the stock portfolio relative to the stock index
	=	return on the stock portfolio to be hedged
	=	return on the stock index
	=	intercept term
	=	error term

The second regression to be estimated to obtain the beta of the stock index relative to the stock index futures contract is

17.5

where

	=	beta of the stock index relative to the stock index futures contract
	=	return on the stock index futures contract
	=	intercept term
	=	error term

Given the estimated betas from (17.4) and (17.5), the hedge ratio is

17.6

The coefficients of determination (the R² or R-squared) of the two regressions will indicate how good the estimated relationships are, allowing the portfolio manager to assess the likelihood of success of the proposed hedge.³

Given the estimates for and , the number of futures contracts needed can be calculated by first determining the equivalent market index units of the market by dividing the market value of the portfolio to be hedged by the current index price of the futures contract:

17.7

Next, multiplying the equivalent market index units by the hedge ratio gives the beta-adjusted equivalent market index units. Since the hedge ratio is given by (17.6), we have

17.8

Finally, by dividing the beta-adjusted equivalent units by the multiple specified by the stock index futures contract, we get the number of contracts that should be used in the hedging strategy:

17.9

Let us illustrate cross-hedging using stock index futures. Suppose that a portfolio manager owned all 30 stocks in the Dow Jones Industrial Average (DJIA) on January 30, 2009. We are assuming that this is the portfolio to be hedged and its market value on that date was $100 million. Also assume that the portfolio manager wanted to hedge the position against a decline in stock prices from January 30, 2009, to February 27, 2009, using the March 2009 S&P 500 futures contract. On January 30, 2009, the March 2009 futures contract was selling for 822.5. Since the S&P 500 futures September contract is used here to hedge a portfolio of DJIA to February 27, 2009, this is a cross-hedge.

Using historical return data, the beta of the index relative to the futures contract was estimated to be 0.745. The DJIA in a regression analysis was found to have a beta relative to the S&P 500 of 1.05 (with an R-squared of 93%). Given these estimates, the number of contracts needed to hedge the $100 million portfolio is computed as follows:

Finally, since the multiple for the S&P 500 contract is 250,

Now, what we have done is set up the hedge. It would be interesting to see what actually happened and why. During the period of the hedge, the DJIA declined on February 27, 2009, such that the portfolio lost . This meant a loss of 11.72% on the portfolio's $100 million. On February 29, 2009, the price of the S&P 500 futures contracts was 734.2. Because the contract was sold on January 30, 2009, for 822.5 and bought back on February 27, 2009, for 734.2, there was a gain of 88.3 index units per contract. Remember that the gain is due to the fact that the portfolio had a short position in the futures contract, which benefits from a decline in the price of the stock index futures contract. Since 380 S&P 500 futures contracts were sold and the gain per contract was 88.3 points, the gain from the futures position was . This means that the hedged position resulted in a loss of $3,331,500, or equivalently, a return of –3.31%. Remember that the unhedged position would have had a loss of .

Let us see why this was not a perfect hedge. As explained earlier, in hedging, basis risk is substituted for price risk. Consider the basis risk in this hedge. At the time the hedge was placed, the cash index was at 825.88. The futures contract on February 27, 2009, was 822.5. The basis was equal to 3.38 index units (the cash index of 825.88 minus the futures price of 822.5). At the same time, it was calculated that, based on the cost of carry, the theoretical basis was 1.45 index units. That is, the theoretical futures price at the time the hedge was placed should have been 824.42. Thus, according to the pricing model the futures contract was mispriced by 1.92 index units. When the hedge was removed at the close of February 27, 2009, the cash index stood at 735.09, and the futures contract at 734.2. Thus, the basis changed from 3.38 index units at the time the hedge was initiated to 0.89 index units when the hedge was lifted. The basis had changed by 2.49 index units alone, or $622.5 per contract (2.49 times the multiple of $250). This means that the basis alone cost $224,100 for the 360 contracts . Thus, the futures position cost $224,100 due to the change in the basis risk.

Furthermore, the S&P 500 over this same period declined in value by 10.99%. With the beta of the portfolio relative to the S&P 500 index , the expected decline in the value of the portfolio based on the movement in the S&P 500 was 11.54% (1.05 × 10.99%). Had this actually occurred, the DJIA portfolio would have lost only $10,990,000 rather than $11,720,000, and the net loss from the hedge would have been $2,601,500, or –2.6%. Thus, there is a difference of a $730,000 loss due to the DJIA performing differently than predicted by beta.⁴

17.1.3.3 Constructing an Indexed Portfolio

As we explained in Chapter 10, some institutional equity funds are indexed to a broad-based stock market index. There are management fees and transaction costs associated with creating a portfolio to replicate a stock index that has been targeted to be matched. The higher these costs are, the greater the divergence between the performance of the indexed portfolio and the target index. Moreover, because an asset manager creating an indexed portfolio will not purchase all the stocks that make up a broad-based stock index, the indexed portfolio is exposed to tracking error risk. Instead of using the cash market to construct an indexed portfolio, the manager can use stock index futures.

Let us illustrate how and under what circumstances stock index futures can be used to create an indexed portfolio. If stock index futures are priced according to their theoretical price, a portfolio consisting of a long position in stock index futures and Treasury bills will produce the same portfolio return as that of the underlying cash index. To see this, suppose that an index fund manager wishes to index a $90 million portfolio using the S&P 500 as the target index. Also assume the following:

• The S&P 500 at the time was 1200.
• The S&P 500 futures index with six months to settlement is currently selling for 1212.
• The expected dividend yield for the S&P 500 for the next six months is 2%.
• Six-month Treasury bills are currently yielding 3%.

The theoretical futures price found using equation (17.1) is:

Because the financing cost is assumed to be 3% and the dividend yield is assumed to be 2%, the theoretical futures price is:

and, therefore, the futures price in the market is equal to the theoretical futures price.

Consider two strategies that the portfolio manager seeking to construct an indexed portfolio may choose to pursue:

1. Strategy 1. Purchase $90 million of stocks in such a way as to replicate the performance of the S&P 500.
2. Strategy 2. Buy 300 S&P 500 futures contracts with settlement six months from now at 1212, and invest $90 million in a six-month Treasury bill.⁵

Let's see how the two strategies perform under various scenarios for the S&P 500 value when the contract settles six months from now. We consider the following three scenarios:

1. Scenario 1. The S&P 500 increases to 1320 (an increase of 10%).
2. Scenario 2. The S&P 500 remains at 1200.
3. Scenario 3. The S&P 500 declines to 1080 (a decrease of 10%).

At settlement, the futures price converges to the value of the index. Exhibit 17.1 shows the value of the portfolio for both strategies for each of the three scenarios. As can be seen, for a given scenario, the performance of the two strategies is identical.

^* Because of convergence of cash and futures price, the S&P 500 cash index and stock index futures price will be the same.

This result should not be surprising because a futures contract can be replicated by buying the instrument underlying the futures contract with borrowed funds. In the case of indexing, we are replicating the underlying instrument by buying the futures contract and investing in Treasury bills. Therefore, if stock index futures contracts are properly priced, a portfolio manager seeking to construct an indexed portfolio can use stock index futures to create an index fund.

Several points should be noted. First, in strategy 1, the ability of the portfolio to replicate the S&P 500 depends on how well the portfolio is constructed to track the index. When the expected dividends are realized and the futures contract is fairly priced, the futures/Treasury bill portfolio (strategy 2) will mirror the performance of the S&P 500 exactly. Thus, the tracking error is reduced.

Second, the cost of transacting is less for strategy 2. For example, if the cost of one S&P 500 futures is $15, then the transaction costs for strategy 2 would be only $4,500 for a $90 million fund. This would be considerably less than the transaction costs associated with the acquisition and maintenance of a broadly diversified stock portfolio designed to replicate the S&P 500. In addition, for a large fund that wishes to index, the market impact cost is lessened by using stock index futures rather than using the cash market to create an index.

The third point is that custodial costs are obviously less for an index fund created using stock index futures.

The fourth point is that the performance of the synthetically created index fund will depend on the variation margin.

In creating an index fund synthetically, we assumed that the futures contract was fairly priced. Suppose, instead, that the stock index futures price is less than the theoretical futures price (i.e., the futures contracts are cheap). If that situation occurs, the portfolio manager can enhance the indexed portfolio's return by buying the futures and buying Treasury bills. That is, the return on the futures and Treasury bill portfolio will be greater than that on the underlying index when the position is held to the settlement date.

To see this, suppose that in our previous illustration, the current futures price is 1204 instead of 1212, so that the futures contract is cheap (undervalued). The futures position for the three scenarios in Exhibit 17.1 would be $150,000 greater . Therefore, the value of the portfolio and the dollar return for all three scenarios will be greater by $150,000 by buying the futures contract and Treasury bills rather than buying the stocks directly.

Alternatively, if the futures contract is expensive based on its theoretical price, a portfolio manager who owns stock index futures and Treasury bills will swap that portfolio for the stocks in the index. A portfolio fund manager who swaps between the futures and Treasury bills portfolio and a stock portfolio based on the value of the futures contract relative to the cash market index is attempting to enhance the portfolio's return. This strategy is referred to as a stock replacement strategy.

Transaction costs can be reduced measurably by using a return enhancement strategy. Whenever the difference between the actual basis and the theoretical basis exceeds the market impact of a transaction, an aggressive portfolio manager should consider replacing stocks with futures or vice versa.

Once the strategy has been put into effect, several subsequent scenarios may unfold. For example, consider an index manager who has a portfolio of stock index futures and Treasury bills. First, should the futures contract become sufficiently rich relative to stocks, the futures position is sold and the stocks repurchased, with program trading⁶ used to execute the buy orders. Second, should the futures contract remain at fair value, the position is held until expiration, when the futures settle at the cash index value and stocks are repurchased at the market at close. Should the futures contract become cheap relative to stocks, the index manager who owns a portfolio of stocks will sell the stocks and buy the stock index futures contract.

17.2.2.1 Risk Management Strategies

Risk management in the context of equity portfolio management focuses on price risk. Consequently, the strategies discussed here in some way address the risk of a price decline or a loss due to adverse price movement. Options can be used to create asymmetric risk exposures across all or part of the core equity portfolio. This allows the investor to hedge downside risk at a fixed cost with a specific limit to losses should the market turn down. The basic risk management objective is to create the optimal risk exposure and to achieve the target rate of return. Options can help accomplish this by reducing risk exposure. The various risk management strategies will also affect the expected rate of return on the position unless some form of inefficiency is involved. This may involve the current mix of risk and return or be the result of the use of options. Below we discuss two risk management strategies: protective put and collar.⁷

Protective put strategies: Protective put strategies are valuable to portfolio managers who currently hold a long position in the underlying security or investors who desire upside exposure and downside protection. The motivation is to hedge some or all of the total risk. Index put options hedge mostly market risk while equity put options hedge the total risk associated with a specific stock. This allows portfolio managers to use protective put strategies for separating tactical and strategic strategies. Consider, for example, a portfolio manager who is concerned about exogenous or nonfinancial events increasing the level of risk in the marketplace. Furthermore, assume the portfolio manager is satisfied with the core portfolio holdings and the strategic mix. Put options could be employed as a tactical risk reduction strategy designed to preserve capital and still maintain strategic targets for portfolio returns.

Protective put strategies may not be suitable for all portfolio managers. The value of protective put strategies, however, is that they provide the portfolio manager with the ability to invest in volatile stocks with a degree of desired insurance and unlimited profit potential over the life of the strategy.

The protective put involves the purchase of a put option combined with a long stock position (Exhibit 17.2). This is the equivalent of a position in a call option on the stock combined with the purchase of risk-free bond. In fact, the combined position yields the call option payout pattern described earlier. The put option is comparable to an insurance policy written against the long stock position. The option price is the cost of the insurance premium and the amount the option is out-of-the-money is the deductible. Just as in the case of insurance, the deductible is inversely related to the insurance premium. The deductible is reduced as the strike price increases, which makes the put option more in-the-money or less out-of-the-money. The higher strike price causes the put price to increase and makes the insurance policy more expensive.

The profitability of the strategy from inception to termination can be expressed as follows:

17.10

where

	=	number of shares of the stock
	=	number of put options
	=	price of stock at termination date (time T)
	=	price of stock at time t
	=	strike price
Put	=	put price

The profitability of the protective put strategy is the sum of the profit from the long stock position and the put option. If held to expiration, the minimum payout is the strike price (K) and the maximum is the stock price (S_T). If the stock price is below the strike price of the put option, the investor exercises the option and sells the stock to the option writer for K. If we assume that the number of shares N_s is equal to N_p, the number of put options, then the loss would amount to

17.11

Notice that the price of the stock at the termination date does not enter into the profit equation.

For example, if the original stock price was , the strike price , the closing stock price , and the put premium (Put) $4, then the profit would equal the following:

The portfolio manager would have realized a loss of $20 without the hedge. If, on the other hand, the stock closed up $20, then the profit would look like this:

The cost of the insurance is 4% in percentage terms and is manifested as a loss of upside potential. If we add transaction costs, the shortfall is increased slightly. The maximum loss, however, is the sum of the put premium and the difference between the strike price and the original stock price, which is the amount of the deductible. The problem arises when the portfolio manager is measured against a benchmark and the cost of what amounted to an unused insurance policy causes the portfolio to underperform the benchmark. Equity portfolio managers can use stock selection, market timing, and the prudent use of options to reduce the cost of insurance. The breakeven stock price is given by the sum of the original stock price and the put price. In this example, breakeven is $104, which is the stock price necessary to recover the put premium. The put premium is never really recovered because of the performance lag. This lag falls in significance as the return increases.

Collar strategies: An alternative to a protective put is a collar. A collar strategy consists of a long stock position, a long put, and a short call (Exhibit 17.3). By varying the strike prices, a range of trade-offs among downside protection, costs, and upside potential is possible. When the long put is completely financed by the short call position, the strategy is referred to as a zero-cost collar. Collars are designed for investors who currently hold a long equity position and want to achieve a level of risk reduction. The put strike price establishes a floor and the call strike price a ceiling.

The profit equation for a collar is simply the sum of a long stock position, a long put, and a short call. That is,

17.12

where and are the strike price of the put and call, respectively, and Call is the price of the call option.

17.2.2.2 Cost Management Strategies

Equity options can be used to manage the cost of maintaining an equity portfolio in a number of ways. Among the strategies are the use of short put and short call positions to serve as a substitute for a limit order in the cash market. Cash-secured put strategies can be used to purchase stocks at the target price, while covered calls or overwrites can be used to sell stocks at the target price. The target price is the one consistent with the portfolio manager's valuation or technical models and the price intended to produce the desired rate of return. Choices also exist for a variety of strategies derived from put/call parity relationships. There is always an alternative method of creating a position.⁸

17.2.2.3 Return Enhancement Strategies

Equity options can be used for return enhancement. Here we describe the most popular return enhancement strategy: covered call strategy (Exhibit 17.4). Other return enhancement strategies include covered combination strategy and volatility valuation strategy.⁹

There are many variations of what is popularly referred to as a covered call strategy. If the portfolio manager owns the stock and writes a call on that stock, the strategy has been referred to as an overwrite strategy. If the strategy is implemented all at once (i.e., buy the stock and sell the call option), it is referred to as a buy-write strategy. The essence of the covered call is to trade price appreciation for income. The strategy is appropriate for slightly bullish investors who don't expect much out of the stock and want to produce additional income. These are investors who are willing either to limit upside appreciation for limited downside protection or to manage the costs of selling the underlying stock. The primary motive is to generate additional income from owning the stock.

Although the call premium provides some limited downside protection, this is not an insurance strategy because it has significant downside risk. Consequently, portfolio managers should proceed with caution when considering a covered call strategy. Although a covered call is less risky than buying the stock because the call premium lowers the breakeven recovery price, the strategy behaves like a long stock position when the stock price is below the strike price. On the other hand, the strategy is insensitive to stock prices above the strike price and is therefore capped on the upside. The maximum profit is given by the call premium and the out-the-money amount of the call option.