Concentrated Stock, a Hard Drawdown Cap, and Three Overlay Choices
A client owns 6,000 shares of a large-cap F&O stock (lot size 500), bought 14 months ago at ₹410; the stock is now ₹560. She wants to keep the shares for at least another 12 months for conviction reasons, but states she cannot accept a drawdown of more than ₹2 lakh from today's price. With 45 days to the quarterly results the market shows: 580 call ₹12, 600 call ₹7, 540 put ₹13, 520 put ₹8. A ₹4 dividend goes ex in 20 days. She has ₹2 lakh of spare cash but will not add money to the position. Her broker has suggested 'writing the 580 call for income, since the shares are anyway yours'. She asks you to compare that with buying a put, and with a collar (buy the 540 put, sell the 600 call).
1. Compute the payoff of each of the three overlays (covered call, protective put, collar) and state whether each satisfies her ₹2 lakh drawdown limit.
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All figures are per share on 6,000 shares; P&L is measured from today's ₹560.
1. Covered call - sell 580 call at ₹12
- Maximum gain at ≥580: (580 − 560) + 12 = ₹32 → ₹1,92,000
- Breakeven: 560 − 12 = ₹548
- Downside: unbounded below 548. At 520: (520 − 560) + 12 = −28 → −₹1,68,000. At 500: −48 → −₹2,88,000.
- Fails the limit - it cushions only ₹12 of a 60-point fall.
2. Protective put - buy 540 put at ₹13
- Maximum loss at ≤540: (540 − 560) + 13 = −33 → −₹1,98,000
- Breakeven: 560 + 13 = ₹573; upside uncapped above that.
- Cost ₹78,000, i.e. 2.3% for 45 days (about 18% annualised).
- Meets the limit, with ₹2,000 to spare - no room for slippage or a wider put.
3. Collar - buy 540 put ₹13, sell 600 call ₹7
- Net debit ₹6. Maximum loss at ≤540: 20 + 6 = −26 → −₹1,56,000
- Maximum gain at ≥600: 40 − 6 = ₹34 → ₹2,04,000
- Meets the limit with ₹44,000 of headroom, at 46% of the put's cost, but caps her at +7.1%.
Note: the 520 put at ₹8 looks cheaper but gives a maximum loss of 48 → ₹2,88,000, which breaches the stated limit by a wide margin. The put strike must be chosen from the risk limit backwards, not from the premium backwards.
2. If she writes the 580 call, what dividend and assignment issues arise over the next 20 days, and what does assignment actually cost her?
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Current position: the stock is ₹20 out of the money with about 25 sessions to the ex-date - early exercise is unlikely today, because the holder would surrender time value and the call still has ₹12 of it.
When it changes: early exercise becomes rational once the stock is above 580 and the call's remaining time value falls below the ₹4 dividend. If the stock rallies through 580 in the days before the ex-date, deep-in-the-money calls will be exercised against her.
Cost of assignment:
- She delivers 6,000 shares at 580 and receives ₹34,80,000; she keeps the ₹72,000 premium.
- She gives up everything above 580 and does not receive the ₹4 dividend (₹24,000), because she is no longer a holder on the record date.
- Any further upside in the shares she wanted to hold for 12 months is gone; re-establishing the position means a new purchase at a higher price, fresh transaction costs and STT.
- Because she has held 14 months, she is already past the 12-month long-term threshold, so 'losing the holding period' is a weaker argument than she believes - the concrete costs are the lost upside and the lost dividend.
A subtlety she will miss: on the ex-date the stock mechanically drops by roughly the dividend. The ₹12 call premium she collected is partly compensation for that drop, so the 'income' is smaller than it looks.
Practical control: if the stock trades above 580 with three or four sessions to the ex-date, roll the call up and out or buy it back before the ex-date; do not let assignment happen by accident, because assignment is allocated randomly among short holders.
3. Recommend a course of action consistent with her constraints and horizon, and explain why the broker's 'income' framing is the wrong starting point.
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Recommendation logic: work from the constraint, not the premium.
- The 540 put alone satisfies the ₹2 lakh limit (₹1.98 lakh) and keeps all upside, but it costs ₹78,000 and leaves no buffer for slippage. It is the right answer only if she truly wants uncapped participation above 573.
- The 540/600 collar costs ₹36,000, caps the loss at ₹1.56 lakh with ₹44,000 of headroom, and caps the gain at ₹2.04 lakh. It is the right answer if she would be content to sell at 600 - a 7.1% gain in 45 days on a position she says she wants to hold for a year.
- A tighter variant worth showing her: sell the 580 call (₹12) and buy the 540 put (₹13), net ₹1 debit - maximum loss 21 → ₹1.26 lakh, maximum gain 19 → ₹1.14 lakh. Cheapest protection, but effectively a decision to exit at 580.
Why the covered call is the wrong tool here: it is short volatility, not long protection. It caps upside at 580 while leaving the downside almost intact (₹2.88 lakh loss at 500). It is a yield-enhancement strategy for an investor with a neutral-to-mildly-bullish view and no drawdown constraint; she has an explicit drawdown constraint and a 12-month horizon. Selling a call against shares does not hedge a concentrated position - only the long put does.
Judgement call: if she refuses to cap upside, buy the 540 put and accept the ₹78,000 cost as the price of the constraint; if cost matters more than upside above 600, take the collar. Do not let her sell the call alone and call it protection.