31 August 2021: Covered call strategy in options trading

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. June quarter numbers of Deepak Nitrite show expansion in both phenolics as well as basic chemicals business 
2. There is a strong demand in the country for phenolics and also exports to countries like the US and China are high.
3. Recently, the government imposed an anti-dumping duty on mica-based pearl industrial pigments for a period of 5 years, which is expected to chemical companies like Deepak Nitrite.
4. The unfortunate arrival of Hurricane Ida on US shores squeezed the already short supply of chemicals in the country. This, however, provides an opportunity for a hike in prices and jump in exports for Indian chemical companies.

Derivatives Build-up:

1. September futures contracts of this stock have witnessed regular addition in Open Interest (OI) over the last few days with another 8.68% addition just yesterday (August 30, 2021). This was coupled with a 6.36% uptick in price at Rs.2,270.20. Increase in OI coupled with increase in price indicates a “Long Build-up” in the stock.
2. Today again the stock is up 1.3% at Rs. 2300.
3. On the other hand, the 2400 call option of the September series has a sizable Open Interest base of 2.38 lakhs contracts and is currently trading at Rs.50. This indicates a resistance for the stock at that level. The lot size for it’s F&O contracts is 500 shares per lot.

Action:

1. Traders who are willing to take short to medium term bullish positions on the stock tend to initiate a Covered call strategy that combines both Futures and Options positions.
2. For instance, if you buy one lot of the September Futures series at the current price of 2300, you must sell the 2400 call option of the current series at a premium of Rs. 50.
3. Now, on expiry, if the stock moves higher to say 2400 levels, the trader will make a profit Rs. 75,000 (Profit on Long Futures: (100*500 = 50,000) + Profit on Short Call Options: (50*500 = 25,000)).
4. However, at the price of 2400, the profit is capped because above this rate every one rupee profit in long futures position will be offset by a one rupee loss in short call option position.
5. But in case the stock goes down, say to 2250 levels, there trader will not make any losses because even though the Futures position will be in loss the Options position will help reduce that loss.
6. Below 2250, the trader will still incur a loss but it will still be Rs. 50 less than what they would have incurred without the hedge.
7. In fact, even if the stock expires at the Futures buying of Rs.2300 you will still make a profit of Rs.25,000 on the short call position.

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. 

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