Covered call is one of the widely used Option Trading strategy to generate a income month on month. Where we simply buy the underlying and short OTM options. The expectations behind Covered Call strategy is Market usually moves up like a snail and drops like a stone.
In this article, we will Buy Nifty Bees and Short OTM options of Nifty. That’s how a Index movements will be, it gradually moves up, so if when short OTM Call options and Nifty doesn’t make any wild upmove, our OTM options expire worthless and thus providing a profit for the trade. Even if there is a upmove, since we already hold the Nifty bees positions, the losses from shorting OTM calls would be offset by profits made by Nifty bees holding.
First we need to gather Nifty historical data and see how it performed month on month for last 10– 12 years to know the volatility of the index. So I checked the monthly returns of Nifty index from 2007 to 2020. This is how the scatter plot of returns looks like, as you can see most of the time Nifty movement was between -5% to +5%, it oscillated between this range only mostly. Out of 174 months, only 38 times, Nifty made more than 5% up move which means 80% of the time, if you short OTM call options that are 5% away, it would expire worthless and generates a income for you.
Out of 174 months, only 9 times, Nifty made more than 10% up move which means 95% of the time, if you short OTM call options that are 10% away from underlying, it would expire worthless and generates a income for you every month. But remember these far away OTM options will have lesser premium.
So we need to find out a optimal strike and keep shorting it every month. So that we get good premium. We considered OTM call options that are 3% away from spot, every month at the start of new expiry, we check this strike and short it.
The covered call strategy has given positive returns when tested with the 12 years of historical data, generating positive returns year on year, with only 2 years negative. Years like 2008 when the market tanked badly, options that we sold has yielded positive returns offsetting most of the losses we incurred by buying Nifty.
If we had invested only in Nifty we would have got 4.5 lacs profits, but with covered call strategy, we can pledge this Nifty that we bought and use that to short call options every month, so that it can generate additional returns over the years, where it generated additional 1.12 lacs with this strategy.