Covered call and Covered put are both one of the best option strategies for those who trade in F&O segment. These strategies are used for reducing the loss if trade goes against our expected trend. F&O is a risky segment which always needs protection for the trader if something goes wrong unexpectedly in the stock. These strategies are very good for positional traders as well as day traders(if the underlying stock is a market mover and shows potential movement in trend).
So what are these covered call and covered put? It is very easy to understand. This is not a rocket science..just simple strategy that needs to be applied with some disciplinary rules which you may consider them as conditions to apply this strategy. They can be applied for both stock as well as index futures and options.
Covered call – Take long in future(buy) and cover that with shorting the nearest call option.
Covered put – Take short in future and cover that with shorting the nearest put option.
Let me explain how this covered call works. If we expect the stock to move up then we take long position in stock future and to protect this we need to short(write) the nearest call option. So, if the stock moves up and meets the target, we will be in profit in FUT. At the same time, we shorted call option and when the stock moves up the call premium also increases. When the stock meets the target we need to cover the long position in future and cover the call option as well. Since we are shorting either At-the-money or the nearest Out-the-money call option, the rate of increase in premium will obviously be less than the rate at which the stock future moves. The profit that we get in future will be reduced to the extent to the premium we need to cover in the shorting of call and the difference in them is our profit earned.
Example: Take JPASSOC which was 124 last week and the 130ca option premium stands at 3.2. If we expect the stock to move up then we take long position in future and short 130ca. When the stock moved 134 then the premium went 8 from 3.2. so, we earned 10rs in Fut and lost 4.8rs in shorting. Difference is 10-4.8=5.2rs is our profit. Lot is 2k..means 5.2*2k = Rs.10400.
Assume, the stock goes down from 124 to 121. Then assume premium in 130ca goes from 3.2 to 1.5. Means, we get 3points loss in FUT but 1.7 points profit in option. So, overall 1.3 is loss but not 3. So, the advantage of this strategy is that it protects from heavy loss in future. One more merit of this concept is, assume if the stock doesn’t move much and stays at 124 till expiry. But 130ca goes from 3.2 to 0. Means there is no profit in FUT but we get 3.2rs in option..which is around Rs. 6400. In other words, if the stock is purely in sideways, this strategy works at its best, apart from purely trendy market.
Same concept applies vice-versa to covered put option strategy but in the opposite direction.
These are the following conditions which need to be taken into consideration before applying these strategies:
1. The stock needs to b a market mover. At the same time it works at its best when the stock is purely sideways.
2. It should have good liquidity in options. Otherwise due to less volume premium will have much varied bid and offer rates.
3. Choose either ATM or OTM options.
4. Both FUT and shorting the option should be taken and covered at the same time. If short not covered then it will be a naked short which is highly risky and loss is unlimited. So disclaimer of risk in shorting naked options will always be there.
Here are the few Nifty stocks which are market movers with good liquid options. SBI, Reliance, Tisco, JPAsso, Renuka, Chambal Fert, IFCI, ICICI Bank. Last but not the least in index category, Nifty Future 🙂