F&O Classroom: Strategy Covered Call a sweetener to long trades

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Options have always been known for its multi-utility. A lot of opportunities present themselves when a single underlying forecast can be traded for all sorts of peculiarity in views with the help of variety of options with respect to Strike and Longevity of Contract a.k.a Expiry.

Many times, such opportunities are attained by bringing in combinations of instruments on the same underlying. Options are coupled with other Options of different strikes or different expiries. These combinations are popularly known as Strategies.

We are going through the current times where we already have recent rise on our back, yet the optimism is that of a further rise. While the optimism keeps us upward oriented in terms of our directional bias, the peculiarity that gets added is that of what happens if we struggle around the current level for a few days. One combination or strategy that comes in handy for times like these is Covered Call.

Let us understand the objective. We want to participate in the Long/ Buy trade. At the same time monetise the possibility of a slower moving or consolidating market. First part here can be achieved with the help of a straight forward Buy position in a Future or for that matter in the Cash market as well with quantity equivalent to the F&O lot size.

Second part of monetizing the consolidating move can be achieved by adding an option to the Long Cash/ Future position. Let us refresh our knowledge before we add this leg, in terms of basic difference between Buy/ Sell, Call/ Put option positions.

Buying Call: Intention to BuySell a Call: Obligation to SellBuy a Put: Intention to Sell

Sell a Put: Obligation to Buy

Out of the above choices all the Buy positions needs to Pay the Premium and Sell position will receive the Premium.

Now with a long asset in hand, the next trading action is to Sell Higher. What if we take an Obligation to Sell higher, which we are already intending to do? We will get rewarded with the Premium to accept this obligation. Buy adding a Sell Call position to the Long Future/ Cash we would create a combination/ strategy called Covered Call.

Covered Call = Long Stock/ Index + Short Higher Strike Call

Let us understand the implications of this. With a Long Position in the Future we are already getting the advantage of any further up move. On the other hand, by selecting a strike close to our target price for the Call sell, we will receive the Premium and accept an obligation to Sell the same Future at a price where we would have anyways Sold.

Finally, one out of following 3 Scenarios can pan out. Let us see the impact of this Combination of the trade.

Scenario #1: Stock Consolidates for next few days as we approach the expiry

In this case, regardless of the fact that the target on the Stock/Index Future is achieved or not, the lapse of time will make sure the Premium on the Call will fall led by passage of time. This will give us a profit in the Position, monetizing the Consolidation.

Scenario #2: Stock reverses and Hits the Stop Loss

Once again, no matter how much time it takes in reversing the rally put in place in recent past, the option value led by the fall in price will fall. This will not monetize the consolidation yet give us something to cheer about from the strategy. We will be able to fund a small portion of our loss from the same.

Scenario #3: Stock rallies instantly

Here is the case where we can get trapped. While the Long position in Future/ Cash will give us money but there will be losses on the Sell position in the Call. However, be rest assured that the losses from the Call will never be more than the profit on the Futures/ Cash. The only sad part is that there will be meaningful Loss in Profit despite of the view being right.

Looking at these 3 scenarios 2/3 cases we are making money out of the strategy and in 3rd we are losing on profitability. To assure that the likelihood of 1st scenario is higher than the 3rd, deploy Covered Call when we are Trading Long Post Rise.

(The author is CEO & Head of Research at Quantsapp.)

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