Covered Call, a best strategy for a slow market: Shubham Agarwal

Do Covered Call only when there is lack of momentum in the market.

Shubham Agarwal

Markets have been slow for the past few days. The loss of momentum does not impact Futures traders much. However, quick entry and exit are not possible in such times. Most of the trades become a wait-and-watch game.

The biggest disadvantage is that due to lack of momentum sometimes we lose patience. Due to this, we end up exiting the trade right before momentum sets in. During such times how about creating a strategy that helps us get money out of a lack of momentum? This is possible when we convert our Buy Futures strategy into Covered Call Strategy.

What is a Covered Call?

Covered Call = Long Future + Short Higher Strike Call

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The strategy is simple; instead of just buying a Futures contract, we buy a Futures contract and simultaneously Sell a Higher Strike Call option.

Normal convention is to sell a Call option with the same expiry and with a Strike Price that is closest to the Target Price of the buy trade. This trade includes two positions, hence the margin requirement will be higher but not so high. Let us understand.

As we all know selling a Call Option has unlimited loss potential if the stock goes up a lot. However, buying Future has unlimited profit potential if the stock goes up a lot.

Because we have both Buy Future and Sell Call together there is a margin benefit. Selling a Call Option and Buying a Future would require more margin if done at different times but if done simultaneously, there is a slight benefit in the margin.

What are the Pros and Cons?

Pros:

1. It is not hidden from anyone that Option premium reduces in value as every day passes by. This decline in Premium is more obvious when there is no or less movement in the price of the stock.

In the covered call Strategy, we will be able to take advantage of this property of options and make money while we wait.

2. Also, when we sell options, we receive premium. Call Option premium goes up with stock price going up and goes down with stock price going down. So, if unfortunately, if the stock goes down after Buying the Future and Selling a Call, we will be losing less money due to profit from Sold Call premium reduction.

Cons:
1. The only disadvantage is that maximum profit in this strategy is limited.

Maximum Profit= Sold Call Option Strike – Buy Future Price + Premium

Example :
Bought Future @100 + Sold 105 Call @1
Max Profit = 105- 100 + 1 = 6

Imagine if the stock goes to 120 after the Covered Call was done we will still be making 6. So, this strategy can not be done always.

When to do a Covered Call?

We should do Covered Call only when there is a lack of momentum in the market. This can be observed from recent days’ and weeks’ movement in the indices. The current time is such time.

What is the Exit Strategy?

Well, just like a Futures trade, we exit the trade at Target (Both Future & Option). Also, the Stop Loss in Buy futures trade should be executed as well.

Both Profit and Loss in Covered Call Strategy are lower with the benefit that if the stock does not move till expiry there will still be profitable due to Sell Call position.

Disclaimer: The views and investment tips expressed by 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.