28 September 2021: Covered call strategy with futures and options

A covered call strategy works as a hedge for short to medium-term trading. This strategy can be employed by traders who wish to hold the stock in Futures and minimise the risk by selling its call option.

Let’s see how this works.

Background:

1.   The Realty index rose 25% in the last few days and hit an 11-year high.
2.     Factors like reduction in stamp duty, lower interest rates coupled with a rise in buying interest ahead of the festive season are some of the major contributors to this rise.
3.   While construction stocks benefited the most in this rally, the entire universe is expected to benefit from the rise in demand, including the housing finance companies.
4.   LIC Housing Finance is a major player in this space and has the ability to source low-cost funds mainly due to its parentage.

Derivatives Build-up:

5.   The stock has risen nearly 10% so far this month and witnessed a significant build-up in Futures in the October series.
6.  The options data shows that the highest open interest base for call options is at 500 strike, which is about 13% higher than the current price of 440.

Action:

7.   Traders who are willing to take a short to medium term bullish position on it tend to initiate a covered call strategy that combines both Futures and Options positions.
8.     For instance, if you buy one lot of the October Futures series at the current price of 440, you must sell the 500 call option of the current series at a premium of ₹8.
9.     Now, on expiry, if the stock moves higher to say 500 levels, the trader will make a profit ₹1,36,000 (Profit on Long Futures: (60*2,000 = 1,20,000) + Profit on Short Call Options: (8*2,000 = 16,000)).
10. However, at the price of 508, the profit is capped because above this rate every one rupee profit in the long futures position will be offset by a one rupee loss in the short call option position.
11. But in case the stock goes down, say to 432 levels, trader will not make any losses because even though the Futures position will be in loss the options position will help reduce that loss.
12. Below 432, the trader will still incur a loss but it will still be ₹8 less than what they would have incurred without the hedge.
13. In fact, even if the stock expires at the Futures buying of ₹440 you will still make a profit of ₹16,000 (8*2,000) on the short call position.