Option Strategy : Covered Call

Covered Call

where an investor holds a long position in an asset and writes (sells) call options on that same asset in an attempt to generate increased income from the asset. 

This is often employed when an investor has a short-term neutral view on the asset and for this reason hold the asset long and simultaneously have a short position via the option to generate income from the option premium.

For example, let's say I own shares of the HINDALCO and like its long-term prospects as well but feel in the shorter term the stock will likely trade relatively flat, perhaps within a few Rs up and down of its current price of, say, 150. If you sell a call option on HINDALCO for 160 Rs, you earn the premium from the option sale but cap your upside. One of three scenarios is going to play out:

• HINDALCO shares trade flat (below the 160 Rs strike price) - the option will expire worthless and you keep the premium from the option. In this case, by using the buy-write strategy you have successfully outperformed the stock.

• HINDALCO shares fall - the option expires worthless, you keep the premium, and again you outperform the stock.

• HINDALCO shares rise above 160 - the option is exercised, and your upside is capped at 160 RS, plus the option premium. In this case, if the stock price goes higher than 160 Rs, plus the premium, your buy-write strategy has underperformed the HINDALCO shares.

1 lot of HINDALCO has 2000 shares ( which approximately translates into 2000 X 150 =  3 lakh Rs  investment). almost all of the lot of different stocks is in the same range. Now lets see how near month price is for different strike price of HINDALCO 
=====================
Strike price     Premium 
150                  8.55
152.5               7.15
155                  6.25
157.5               5.40
160                  4.50
=====================
At strike price of 160, which is OUT-OF-THE-MONEY, call option can be relatively safely sold and premium of 4.5 Rs, which translates into  4.5 X 2000 = 9000 Rs , from an investment of 3 lakh, which translates into 3 % monthly return (36 % annual return  Quite decent return !!!!) 

A more sophisticated investor can use future in place of stocks to implement the same strategy, but the risk involved and skill requirement is quite high. 

Source : Wikipedia

This strategy is best used when the investor would like to generate income off a long position while the market is moving sideways. It allows an investor/writer to continue a buy-and-hold strategy to make money off a stock which is currently inactive in gains. 

The investor/writer must correctly guess that the stock won't make any gains within the time frame of the option; this is best done by writing an out-of-the-money option. 

A covered call doesn't have as much potential for reward as other types of options, thus the risk is also low.

Time Decay

The passage of time has a positive impact on this strategy, all other things being equal.  As expiration approaches, an option tends to converge very fast on its intrinsic value, which for out-of-money calls is zero.

Main point of this strategy :

1. It has limited profit potential.
2. It has unlimited loss potential.
3. Once the strategy is introduced, reduction in volatility is beneficial for this strategy.

A note of caution

As long as the short call position remains open, the investor isn't free to sell the stock. It would leave the calls uncovered and expose the investor to unlimited risk by making it a naked call.

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F 'n' O Indicators

Trends in the F&O can reveal broader trends in the cash market that can be used while transacting in equities. Investors can look at various parameters and ratios to gauge the mood of the market and determine in the investment strategy. F&O numbers give a hint about the short-term market movement. A note of caution: investors should use the F&O trends as one of the tools in the decision-making process and not completely rely on them for investment calls.

 This is because the liquidity or trading is concentrated in the Nifty index and in 20-25 stocks in the F&O segment. Liquidity is necessary for better price discovery. A few stocks go without trading for many days.

Among index futures, the Nifty futures account for over 90% of trading. Around 250 stocks are traded regularly in the futures segment. The top 10 contracts contribute to over 35% of the total traded volume in individual stocks in the futures segment. In the option section  Nifty options comprise around 98% of trading in options. Of the 265 stocks eligible for the derivatives trading, less than 100 stocks are traded regularly in the options segment. The top 10 stocks account for over one-third of trading in the options market. Stock futures are more liquid than stock options. Thus, investors have to ensure that the stocks they are examining in the F&O segment have good volume to decipher the trend in the cash market. So now let's move to F 'n' O Indicators.  

Premium or discount to the cash market:

First, inspect if the stocks or indices are trading at a premium or discount in the derivatives market compared with their underlying to predict whether the market mood is bullish, bearish or indecisive. Suppose stock futures or index futures are trading at a premium compared with the underlying stock or index. This points to a bullish trend in the cash market. But a stock or an index trading at a discount in the futures market indicates a bearish market.Investors can also look at the quantum of premium/discount to the spot market.

 Quantum of premium or discount 

To understand the magnitude of the bullishness or bearishness. If a particular index is trading continuously at a premium, it would indicate buoyant market sentiments. However, if the premium turns negative (discount) to the underlying stock or index, it would mean the stock or the market is weakening or likely to weaken in future. 

But care must be taken when considering the dividend on stocks. 

Future price will be in discount if there is a dividend EX date announced in that particular month. Then the Future price is equal to Cash price minus dividend amount. That means future price is lesser than cash price which does not mean that stock is bearish.  

Put-call ratio: 

This ratio is also known as the put-call volume ratio. It is widely used to understand the sentiments prevailing in the cash market. The put-call ratio is calculated by dividing the daily or weekly traded volume of put options by the daily or weekly traded volume of call options. This ratio is not only easy to calculate but also simple to interpret. Higher the number of call options traded higher are the chances of the market turning bullish in future. If put options are more popular, bears could dominate the market.

An increasing ratio over a period of time means investors are putting more money in put options, implying the broad market outlook is bearish. Thus, the market can be expected to move south or witness a sell-off.This could also be the case of investors trying to hedge their portfolios. On the other hand, a declining put-call ratio indicates investors are showing more interest in buying call options and the market is likely to move up in the near future.

 Extreme values point to a trend reversal in the coming days. This can also be termed as a contrarian indicator. An increase in the ratio to unjustifiably high levels is considered a buying opportunity as traders start covering their short positions. On the contrary, too many call options or a low put-call volume ratio signifies the market has reached an overbought level and a correction is likely. In short, a very high put-call ratio indicates the bear phase is likely to end, while a very low ratio means bulls could lose the grip over the market and a market correction is likely.  

Put-call open-interest ratio:

The put-call open-interest ratio is also one of the key indicators of possible futures movement in the spot market. The put-call open-interest ratio is calculated by dividing the total open interest of put options by the total open interest of call options. For instance, if the open interest for put options is nine and the same figure for the call options is 10, the put-call open-interest ratio would be 0.90. A put-call open-interest ratio of more than one means put options have a higher open interest compared with the call options and, thus, the future price trend is likely to be bearish. A low put-call open-interest ratio means bullish sentiments are likely to continue in future. Investors can monitor periodical changes in the put-call open-interest ratio to gauge future market outlook.

The daily Put/Call ratio can be found out by clicking the link and then accessing the data  for current month of the year.

Daily volatility:

Investors prefers a bullish market and perceive it safe as well. On the contrary, a bearish market is considered risky. Therefore, increase in daily volatility is considered bearish, while lower or moderate volatility is taken as a sign of a bullish market. Daily volatility represents volatility of the future contracts on a particular underlying stock or index. These figures are available on the NSE website. India VIX represent the daily volatility on overall market on the NSE.

The daily India VIX data can be found out by clicking on the link.

Rollover:  

The near-month F&O contract expires on the last Thursday of the month. At the time of expiry or close to expiry, investors will find news articles discussing rollover. Rollover is applicable to future contracts and not options. If an investor is holding a position in futures, he will close his position in the near month or in the current month and take a fresh position in the next-month contract. Rollover helps investors to carry his position for a longer period of time. The investor will find the Nifty futures with expiry in next month at a slight premium. he will have to bear the difference. Further, the investor will have to bear transaction-related expenses such as brokerage.

The percentage of outstanding positions rolled over to the next month is used to gauge market sentiments. A higher percentage of rollover symbolises bullish undertone, while a lower rollover indicates bearishness. It is difficult to comment on the market mood by just looking at the rollover figures. Investors have to use other numbers to deduce the right conclusion. Every buy side has a sell side to it. As a rule of thumb, if the market is in a bull phase, a high percentage of rollover could mean the market would remain firm or move up in the near future. In an extremely bearish market, a high rollover could spell trouble as it could denote that the bears are convinced the market would fall in the future.

Open interest and change in open interest: 

Open interest in the F&O market along with price movement and traded volume is also used by traders to predict future trends. Open interest is basically the total number contracts — futures or options — that remain open at the end of the day. 

Don't get confused with open interest and volume of trade. Volume of trade and open interest are different. Volume is total no of transacted contract for the day and open interest is total number of contract (buy) that still needs to be closed by going opposite transaction.

 

 

 

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Option trading on Nifty index

options are financial instrument which offer the highest return on investment but require a lot of understanding to operate otherwise can cause huge loss to the investors. In technical term :

option is a contract between two parties 
to buy/sell a certain asset 
at certain specified price 
at certain specified date 
after paying a amount. 

 Asset  becomes  underlying in option technical terms. similarly
specified price = Strike price ,
specified date= Expiry date and
amount is called premium in option vocabulary.


For example  Mr. Singh and Mr. Modi  entered into a contract in which Mr. Singh agreed to buy 100 tones of wheat from Mr. Modi on 15 may at price of Rs.15000 per tones and paid an advance of 50000 for this booking.

Here,
Strike price is Rs.15000/tones
Underlying =100 tones of wheat
Expiry date is 15 may.

If Mr. Singh choose not to buy it from Mr. Modi ,he will loose his initial amount paid, such a situation can arise when  the market price of wheat fall to say Rs.12000/tonne. In this situation Mr. Modi keeps the money in his pocket (this is the money paid to him as risk premium)

In the next article i will write more formally on options. keep visiting and do give your feedback about what you need which i can cover in my postings.

::: Be informed, Be cautious and most importantly, Be wise in trading

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