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:
Infosys is a leader in the IT sector and posted robust numbers for Q2FY22.
The management said that the company witnessed broad based growth across all sectors and core geographies, with the Digital business growing at 42% YoY.
E&U growth accelerated further and saw large deal wins.
Derivatives Build-up:
After a strong run-up to highs of ₹1,808 last month, the stock had corrected nearly 8% to ₹1,669 levels. The stock has now bounced back to ₹1,760 levels.
The December options data of Infosys shows a significant open interest base for call options at 1,800 strike, which is nearly 2% higher than the current price of ₹1,760, suggesting that the stock might face resistance at that price
The lot size in the F&O contract is 300 shares per lot.
Action:
Traders who are willing to take a neutral to moderately bullish position tend to initiate a covered call strategy that combines both futures and options positions.
For instance, if you buy 1 lot of the December futures expiry at the price of ₹1,760 then one can sell 1 lot of 1,800 call option (OTM call) of the December expiry at a premium of ₹20.
Now, on expiry, if the stock moves higher to say ₹1,800 levels, the trader will make a total profit of ₹18,000 (Profit on Long Futures: (40 * 300 = 12,000) + Profit on Short Call Options: (20 * 300 = 6,000).
However, at the price of ₹1,820, the profit is capped at ₹18,000 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.
But in case the stock goes down, say to ₹1,740 levels, the trader will not incur loss because even though the futures position will incur loss but the call option position will cover that loss. This is the break-even point for the strategy.
Below ₹1,740, the trader will incur a loss on the Futures position but it will still be ₹20 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 ₹1,760 one will still make a profit of ₹6,000 (20 * 300) on the short call position.
To know the margin required to execute this strategy, you can click on this link: https://upstox.com/calculator/span-calculator/
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 be coming with a lot of strategies which 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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