Covered call strategy in options trading

A covered call strategy works as a hedge for long-term investors in stocks. This strategy can be employed by continuing to hold the stock and by selling its call option. 

Let’s see how it works.

Background 

1. The Tata Motors stock is witnessing near-term pressure due to chip shortage affecting the JLR business and the pandemic disrupting its India business. 
2. While in the long term, these issues are expected to be resolved; in the near term the business is being adversely affected.
3. The stock is currently trading at ₹284. It is down nearly 3% so far this month so far and over 20% down from its yearly highs. This looks worse when you compare it with Nifty which is close to its lifetime highs. 

Derivatives build-up

1. In the Derivatives segment, as on 25th August, the stock has the highest open interest buildup at the 300 strike price call option with 61 lakh contracts for the September series. Typically, a high open interest buildup at a particular strike price in call options implies that the option writers (sellers) foresee a resistance at that price.
2. The said strike price has witnessed an addition of 59.85% (or 36 lakh) contracts. Addition of contracts at this particular strike price suggests more participants believe that stock will trade below ₹300 for a good part of the next month.
3. The put-call ratio, which indicates the total number put option contracts divided by the total number of call option contracts, for the said strike price is at 2.44 indicating a fair resistance at 300 levels for the share.

Action

1. Long term investors in Tata Motors who wish to make money on this share without selling their holdings can initiate a covered call strategy. 
2. For instance, if they sell the September series 300 strike price call option, which is trading at ₹9.45 at the moment, they will pocket ₹26,932 (lot size 2,850 * premium ₹9.45).
3. This call expires on 30th September and if the stock prices remain at or below ₹300, you get to keep the entire premium as your profit.
4. If the stock moves higher, say above ₹309.45, you will make a loss but the shares that you hold will gain. The assumption here is that the investors who implement this strategy hold at least 2,850 shares, which is equal to a single lot of the Tata Motors’ options contract.

About the author: Kush Bohra is a SEBI-registered investment advisor and an F&O expert.

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.