Trader’s Edge: A trading strategy that lets you own an asset for free

How would you like to get your assets for free?

This is what Sharath Babu (@sharath82), an IT professional turned trader, asked when talking to Moneycontrol about his trading strategy that focuses on generating extra alpha on his investments.

The trading strategy he follows is not novel. It is something that is even used by equity mutual fund managers. However, thanks to the profits from the strategy he has recovered the cost of many of his equity investments, eventually owning those assets for free now.

Sharath, who identifies himself as a conservative trader, sells call option contracts of stocks he already owns – a strategy also known as covered calls – pocketing a premium every month that supplements the dividend income from them.

From noob to an expert

Many traders who entered the market in recent years can find familiarity in Sharath’s journey in the stock market. He has committed the same mistakes that many others have and learned from them.

Sharath says he opened his Demat account courtesy of pressure from a friend who worked with a broker. His first-ever investment was buying shares during the IPOs in the bull run of 2003-07. His idea was to make quick bucks. Since the period was similar to what happened in 2020-21, he made some money in them.

After years of booking small profits and buying stocks on recommendation from his friend, his attitude changed when he saw one of his managers at Infosys quit his job much ahead of retirement age. When Sharath asked how he would manage expenses now, the manager’s answer was simple: I own Infosys stocks. The dividend will take care of everything. From then on Sharath started investing in the long term.

Though, amid these sane decisions, he also took some bad ones. In 2016, after being impressed by one of the fund managers on TV, he invested in his PMS fund, which he said was the “biggest mistake”. He lost about 50-60 percent money at that time.

Around this time he came in contact with another influential trader for guidance, who is known for his risky trades. Surprisingly, the latter’s first advice was to put money in a bank with fixed deposits. The second one was to buy units of any balanced advantage fund. On Sharath’s insistence, the trader finally started teaching him bits of trading.

Even after years of trading, Sharath remains relatively conservative as he does not buy or sell any naked options. Most of his money is still in the form of investments generating dividends. He terms his style of trading as risk-defined trading.

Trade setup

The idea behind the covered call strategy is to take benefit from short-term volatile movements in your portfolio stocks. He does not employ this strategy for his entire holding but for some of the largest ones. Please note that the covered call strategy can only be employed in F&O stocks. The setup is as follows:

Step 1: Pick some of the largest holdings in your portfolio. Make sure that the stock has enough liquidity in the options market.

Step 2: You need to sell calls for an equal amount of shares you hold. For instance, if the lot size for a stock is 250 shares, then you need to hold 250 shares in your cash portfolio to employ this strategy, otherwise, it will not work. Now, for this example let’s assume you hold 2500 shares of the stock.

Step 3: Around the 18th or 19th of a month, sell call options for two lost for the next month's contract with a premium of 0.7-0.8 percent of the stock price. For instance, if the stock is trading at Rs 1,000, sell the strike for which the premium is Rs 7-8. The next two lots for a relatively lower premium, say Rs 6, and another two lots for an even lower premium, say Rs 5. Sharath does this “incremental covered call” so that he does not have to give delivery of all holdings if something goes horribly bad.

Step 4: Rollover your position for next month around the 18th or 19th (as during expiry week the volatility is too high and you may suffer big losses), again selling next month’s call option. You may have to adjust your strikes according to stock price movement.

Explanation for novice traders

A call option buyer gets the right to buy a stock at a set price called the strike price, even if the stock price goes higher than the strike price. For example, if you buy a call option at Rs 1,100 strike and the stock is trading at Rs 1,000. To buy this right, you have to pay a certain premium to the seller. Let’s assume that is Rs 10. Also, assume the seller bought the stock in the cash market at Rs 900. Now there are three scenarios:

-If the stock price hits Rs 1,100 or higher, a buyer can ask for delivery. In the case of covered calls, the seller will gain a premium plus the profit on delivery of shares, which is Rs 1100 minus Rs 900.

-If the stock remains above Rs 1000 but does not hit Rs 1,100. The seller will keep the premium and the stock and will thank the buyer.

-If the price goes below Rs 1,000, the seller will be in a notional loss only when the stock price goes below Rs 890 (cost price minus the premium received). In case he bought the stock for the long term, the losses will just be on paper and the premium gained will be real.

Risk management

By nature, the covered call strategy is used to manage risks. You can simply understand it as a rental income for the stock which is lying in your Demat account. As you can see above, the seller benefits most of the time.

Sharath says his aim is to bring down the cost of acquisition month on month by earning premiums. He says in 4-5 years, he manages to bring down the cost price to zero.

Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.