Hi
i like to trade in the money covered call. so if someone please let me know how to trade, and risk factors i need to consider.Also about intrisinc value and profit loss calculation
Hi Mohan,
Covered call is an income strategy. The underlying premise is that you own the stock in your DEMAT account as a long term investment and want to generate an active income over your otherwise passive investment.
Assume you own 1000 shares of ITC in your account and ITC is trading at 335. The lot size of ITC is 1000. The covered call strategy would be to sell ITM or slightly OTM option and receive the credit/income.
In this case ITM = 335. Lot size is 1000, LTP = 12, therefore the income when you write this option is 1000*12 = 12,000/-
At expiry, 3 things can happen...
Scenario 1 - Stock price stays at 335
In this case you retain the premium.
Scenario 2 - Stock price goes below 335, lets say 300.
In this case you retain the premium of 12K which would offset the partial loss in the spot market. Also remember that the spot market investment is supposed to be long term.
Scenario 3 - Stock price is more than 335, lets say 360.
The option price will be 25 (360-335) of which you have received 12 as premium therefore your loss is 13.
However the loss on your option is COVERED by the gain in your spot.
Your gain in spot is 25, deduct the option loss of Rs.13, your net gain is Rs.12.
The key is to have quantity in spot equivalent to the lot size.
3 Likes
Couple of additional points, mostly related to risk factors
Suppose one has bought 1000 ITC today at 335 and at same time sold 335 Call for 12. Expiry is on 31 July
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ITC has a strong up-move to say 360 within next one week. Though spot has moved to 360, the call could move to 45 odd levels - due to increased volatility as well as it is now deep in the money. Now what does one do, spot is 25+ while call is 33- resulting in net loss of 12 even though ITC moved 25+ points. Yes one can wait but then there is always possibility of reversal through the entry price. Yes ITC could keep moving up till expiry but then one has limited one’s profit to only 12 points that one received on the on sale of premium.
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What if ITC moves down to 300 due to some reason in the next one week. During this time the call may move to only about 8 levels - though it is out of money now it will still have some value due to time value and implied volatility. Now what would one do, spot is 35- while option is only 4+ resulting in net loss of 31. Yes one could wait till expiry hoping for recovery but what if the price keeps going down.
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Liquidity risks with the option contracts. Not all option contracts are liquid and liquidity of contract changes from time to time as the underlier moves. There have been cases where people have not been able to book profits in options due to lack of liquidity.
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Buying 1000 ITC in cash would require a comparatively large investment amount.
Thus this is a high risk low reward strategy which would work in only very limited scenarios of price remaining between cash purchase price and option strike price. Incase of down trend loss would be huge and in case of uptrend profit would be limited. One huge loss could wipe of profits of many trade.
3 Likes
Excellent explanatioin.
Thanks for putting the risk factors on desk!
@ksksat @ajay I would like to have some clarification here…lets say ITC in this example moves to 360 or even above …and u said premium will go up more in proportion to price so if you see MTM …it will show loss but this is actual loss only if you book (square off your position) .
If you let it expire and spot price is lets say 360 …can you deliver the stock you have in your demat based on that you wrote covered call? so basically your 335 rs. stock which could have been sold at 360 with 25 Rs. profit …now it has only 13 Rs. profit (25-12) correct?
Also will zerodha let it expire or they will square off before expiry because it is going against you?
This is correct, I think the previous explanation is misleading. There is no loss if price shoots up, only that your upside is capped.