Covered Call Strategy for Option Trading Beginners

A covered call strategy is an options trading strategy in which a stock or other underlying asset is owned and a call option on that asset is sold. The aim of this strategy is to generate income from the option premium while also limiting potential losses in case the stock price goes down.

How it operates?

Let’s understand this with an example.

Instrument: Nifty.

Monthly Return Expectation: 1-2%

The Nifty Index is trading at 17800, and the lot size of the Nifty is 50 qty. So the total value of the Nifty contract is 17,800 x 50 = 8,90,000. To do a covered call strategy, you should buy the entire value of the contract for Nifty in the cash or equity segment.  

But how do you buy Nifty in the cash segment?

No, you can’t; but, we have three ways to own the Nifty index –

1. Buy all the 50 stocks of Nifty 50 Index in cash with the same index weightage – but buying all the stocks and keeping check on weightage and adjustment is a painful task and expensive.

2. Buy Nifty Futures – We can buy futures by simply paying margin money, but there are some challenges, such as:

• We must rollover each month, and there is a rollover fee.
• Futures require a 0.5% premium, which is expensive.
• They can’t be pledged for margin.

3. Buy Nifty ETF – Best instrument to own index in portfolio.

• ETF is one of the best instruments for this strategy. 
• Requires investment of ~ Rs. 8,90,000 in Nifty ETF.

How can an ETF be used in a covered call strategy?

The majority of large-cap mutual funds underperform their benchmarks. Investing in index ETFs is thus the best way to achieve benchmark returns with a lower expense ratio.

Nifty Bees is the best ETF to buy for a covered call strategy because:

• Nifty bees is most liquid in Index ETF category
• You will get ~90% of the value as collateral funds

Let’s say you have purchased Nifty Bees at Rs. 94, which is worth Rs. 8,90,000, you can opt for a margin pledge with Paytm Money to get around 90% of the value as collateral funds, which amounts to approximately Rs. 8,00,000, which you can use as collateral margin for F&O trading.

Now, sell OTM Nifty Options

• You should now sell the month’s Out of the Money (OTM) Nifty options. 
• To sell one lot of Nifty options, a margin of Rs. 1,00,000 is required. 
• If your expected return is 1% per month, you must earn Rs. 1000 (1,00,000×1%) from selling call options.
• To earn Rs. 1000, sell any OTM call option trading between Rs. 20-25 at the start of the month (20×50 qty = Rs. 1000).
• You may need to sell 600 to 700 points of Nifty OTM call, which is 4% below the current index price. Because the possibility of the index moving 4% every month is less, you have a higher chance of success.

If the stock price remains below the strike price, the call option will expire worthless, and the seller keeps the premium as profit. If the stock price rises above the strike price, then the seller will lose money in option selling, but that will be compensated by Nifty Bees profit.

Note: You should not sell more than one lot of options because you have Rs. 8,90,000 worth of Nifty Bees, which is equal to one lot of Nifty contracts.

Can we use stocks for this strategy?

Stocks are extremely volatile, ranging from 10% to 20% up or down in a single month. So as a trader, the index is a better instrument for Covered Call strategy. 

Conclusion:

A Covered Call strategy is an options trading strategy that can provide income from the option premium while also providing some downside protection. However, it is important to carefully consider the potential risks and rewards before executing the strategy. It is recommended to consult with a financial advisor before implementing this strategy to ensure that it aligns with your investment goals and risk tolerance.