A covered call strategy in options works as a hedge for short- to medium-term trading. This strategy can be deployed by traders who wish to hold the stock in futures and minimise the risk by selling its call option.
Let’s understand how this strategy works.
Background
Cholamandalam Investment and Finance Company (CholaFin) is a leading asset financer with presence in vehicle financing, loan against property and home loans.
The company recently declared its results for the September quarter (Q2 FY22) and saw a revival of disbursement and collection trends versus the June quarter (Q1 FY22).
It also saw robust year-on-year growth in disbursements and profit-before-tax in all three business verticals.
Derivatives build-up
After a strong run-up to a high of ₹637, the stock had corrected nearly 13% to ₹554 levels. The stock has now bounced back to ₹612 levels.
The November options data of Cholamandalam Inv. (CHOLAFIN) shows a significant open interest base for call options at 650 strike, which is nearly 6% higher than the current price of ₹612, suggesting that the stock might face resistance at that price
The lot size in the F&O contract is 1,250 shares per lot.
Action
Traders who are willing to take a short to medium-term bullish position tend to initiate a covered call strategy that combines both futures and options positions.
For instance, if one buys 1 lot of the November futures expiry at the price of ₹612, then one can sell 1 lot of the 650 call option of the November expiry at a premium of ₹14.
Now, on expiry, if the stock moves higher, to say ₹650 levels, the trader will make a total profit of ₹65,000 (profit on long futures: (38*1,250 = 47,500) + profit on short call options: (14*1,250 = 17,500).
However, at the price of ₹664, the profit is capped at ₹65,000, because above this rate every rupee of profit in the long futures position will be offset by a rupee of loss in the short call option position.
However, in case the stock goes down, say to ₹598 levels, the trader will not incur a loss because even though the futures position will incur a loss but the call option position will cover that loss. This is the break-even point for the strategy.
Below ₹598, the trader will incur a loss on the Futures position, but it will still be ₹14 less than what they would have incurred had they not sold the call option.
In fact, even if the stock expires at the futures buying price of ₹612, one will make a profit of ₹17,500 (14*1,250) on the short call position.
We hope this strategy was simple and easy to understand. You can try spotting it on the option chain and see if you are able to identify levels.
We’ll bring you a lot of strategies that will help you to identify trade setups easily.
Until then, happy trading!
About the author: Kush Bohra is a SEBI-registered investment advisor and an F&O expert.
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Disclaimer:
Derivatives trading must be done only by traders who fully understand the risks associated with them and strictly apply risk mechanisms like stop-losses.
We do not recommend any particular stock. The stock names mentioned in this article are purely for showing how to do analysis. Take your own decision before investing.