Covered Calls using futures as the underlying (rather than stock)


#1

So, typical covered call- Own the underlying stock, Write OTM call

Rather than owning the underlying stock in cash & carry, I own a futures contract on that stock. Then I write covered call on that.

Benefit of the above- Less capital requirement (~ approx 50K margin blocked + MTM, rather than 5 lakh tied in buying the stock outright)

Problem with the above- I loose premium paid on the future (this basically wipes out everything I earn from the covered call premium).

IS there some way I an save the premium? I can write 2 CE with deltas less than 0.3 (one CE to pay for the premium I need to give for the future and 2nd CE to actually earn me something on the covered call). But this increases my risk as the 2nd CE is basically a naked one.

Anyone else suffering the same problem and any ideas how can we save the premium?


#2

I’m unable to understand how you’d lose out on Futures premium. You anyway have the advantage of lesser capital outlay (as compared to a classic CC).


#3

if You write covered call after buying and if prices down below your buy price and closes below then you will incur huge losses because your maximum profit is only premium received.

for eg. as of Today closing SBIN Futures is 252 and 270CE is 1.00

you get premium of Rs, 3000/-

on expiry day if Futures price goes to 250 then you will end up in loss of 3000/-.

Also some times Futures trade with some discounts to underlying stock,


#4

Hi Karthik,

Please consider the following -

Ex : Two scenarios for Covered calls -

Scenario 1: I bought HDFC Bank (in cash) 500 shares @ 1400 each (7 lakh capital tied). Wrote Covered Call on it.

Scenario 2: I bought HDFC Bank Future 1 lot @ 1410 (~50K capital tied). Wrote Covered Call on it.

At expiry: HDFC Bank expires at 1500. I would have got 100 Rs on my underlying (if bought in Cash). I would get 90 Rs on my underlying if bought in Future. (Forget the call written on it as it will be same in both cases, so not a deciding factor).

In effect, I am paying Finance charge of 10 points premium(i.e. 5,000 Rs) for getting benefit of less capital being tied (50K instead of 7 lakh). So, I am paying almost 9% per annum of finance charge/interest to use that 6.5 lakh capital).

In effect, I am not earning anything on the “Covered Call” part (Whatever I get in premium by writing an OTM call on the underlying future, I give it back as the loss of premium on the Future in way of Finance charge). Ofcourse I earn on the underlying, but it is is simply a directional bet rather than earning income through the covered call.

I hope you get my point.


#5

Hi AB1,

Good question, Even I was wondering the same the other day and stumbled on to this Post. Here’s my observation

You can replicate a Stock holding by going long on futures and rolling it forward every month, but like you said you need to pay a carry cost of 9%, though I notice it is close to 7.5% or 8% now a days. So as long as the stock appreciates more than the carry cost you are better off holding the Futures than the underlying stock. This is a strategy that I have tried and does work. But we need to make sure of the below things.

  1. The stock is not overbought when you go long on the Futures
  2. The stock should be in a long term upward momentum
  3. Your futures position will yo yo between a profits and losses depending on the movement on the underlying. You need nerves of steel to hang on to it.

Once you got the pros and cons of holding a long position via futures, a covered call with futures is simple enough. But there is a catch in covered call. In a covered call the upside is capped but the downside isn’t. So if the stock drops 10% in the first month and goes up by 11% in the next, although the stock remains where it was at the end of the second month, you would have lost some money. This is a risk in both the case, whether you hold the underlying stock or the long futures. So my strategy was to keep a buffer between the Stock price and the strike price atleast 5% i.e. sell an OTM call option and not ATM option, this may reduce my returns but atleast saves me from the risk mentioned above. To kick up the returns a bit I sell a further OTM put option too. You can be reasonable assured the put would not be exercised since the stock is in an upward momentum. And make sure you sell options in a high volatile period to scoop in as much premium as you can. I have tried this structure on Tech Mahindra and Infosys. Let’s see how it works out.


#6

Hi All,
I have been buying Futures and selling calls since a few months now. It may make sense to sell deep ITM (In the money) call which is at a strike lower than the support level of the stock and the stock is either moving sideways or is in an uptrend. The idea is to choose a strike at which the probability of stock to go down to may be lower. As long as the stock futures price remains above the lower (ITM) strike price, we will make money on the extrinsic value of the premium earned on the call sold. We need to avoid the possibility of rolling over the stock futures to the next month but instead to end the current settlement at a profit or a small loss. To ensure a small loss, we may buy an OTM Put in case the stock future price tends to go below the strike price at which the Call was sold


#7

Agreed. After a lot of research and trading I have found it to be one of he best strategies that actually generate small but consistent returns. Buying OTM options does allow you to profit from up moves and premium collection but when the stock tanks down you loose quite a lot so instead, selling a little deep in the money options to collect decent premium with good downside protection seems to be the best possible combination.
Only disadvantage is that with OTM Covered Call you can achieve your profit early and close the trade before expiry if you like, if stocks moves up in your favor however with deep in the money options you can’t take advantage of any up move and you have to wait till expiry to realize your max profit.