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
Vedanta is engaged in exploring, extracting and processing metals, minerals and oil.
The company posted robust year-on-year growth in revenues aided by a rise in prices of major commodities and higher demand.
Increasing commodity prices and higher volumes coupled with cost optimisation are expected to help improve the operational efficiency of the company.
Derivatives build-up
In the last one month, the stock had a strong run-up to highs of ₹387 and then corrected nearly 23% to ₹297 levels. The stock has now bounced back to ₹333 levels.
The November options data of Vedanta (VEDL) shows a significant open interest base for call options at 340 strike, which is nearly 2% higher than the current price of ₹333, suggesting that the stock might face resistance at that price. The lot size in the F&O contract is 3,100 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 one buys 1 lot of the November futures expiry at the price of ₹333 then one can sell 1 lot of 340 call option (OTM call) of the November expiry at a premium of ₹7.
Now, on expiry, if the stock moves higher to, say, ₹340 levels, the trader will make a total profit of ₹43,400 [(profit on long futures (7 * 3,100 = 21,700) + profit on short call options (7 * 3,100 = 21,700)].
However, at the price of ₹347, the profit is capped at ₹43,400, because above this rate every one rupee of profit in the long futures position will be offset by a one rupee loss in the short call option position.
But in case the stock goes down to, say, ₹326 levels, the trader will not incur a loss. This is because even though the futures position will incur a loss, the call option position will cover that loss. This is the break-even point for the strategy.
Below ₹326, the trader will incur a loss on the futures position, but it will still be ₹7 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 ₹333, one will still make a profit of ₹21,700 (7 * 3,100) 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 is 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 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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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.