Last week, we compared the put strategy with the preemptive sell strategy as a way to take profit from a primary position. This week we discuss how you can use a covered call strategy to take profits on your underlying position.
A covered call involves shorting a higher strike call against your underlying position. The goal is to shorten the strike that is likely to expire out of the money (OTM). Therefore, covered buying usually involves short selling of a call option that is one strike above the resistance level of the underlying.
But our goal here is basically to make a profit. Therefore, you should sell a put option closer to the target price. The goal is to let the option expire in the money (ITM) so that you deliver the stock against the short position. This strategy will only work if you have stock in multiples of the options allowed lot size.
For example, if you want to place short calls on ICICI Bank to take earnings per share, you must have 1,375 shares or multiples thereof. The strategy works best if you have enough shares that selling one call option contract helps you take profit of 50 percent of your underlying position. In the case of ICICI Bank, that would mean owning 2,750 shares of stock.
You should sell the near month option because the intent is for the stock to be called sooner rather than later to lock in profits. It would be better to shorten the call when the contract has at least two weeks to expire; That will help you get great time value on the option.
Suppose you short your November 900 call on ICICI Bank at 16.65 pips. If the stock closes above 900 when the contract expires, you must deliver 1,375 shares at 900 each. Your total profit would be 2.2 lakhs (160.65 points multiplied by 1,375), assuming you bought ICICI Bank shares at 756. Note that the call premium adds to your earnings.
What happens if I close the position before it expires? Suppose 15 days before the contract expires, ICICI Bank approaches 900. You can close your buy position by buying the option. The option can be worth 26 points. Your profit will then be 134.65 pips. This is because losing 9.35 pips on your short call reduces your underlying profit.
Alternatively, you can hold your short call position until expiration even if the stock moves above the strike level. Your margin requirement will increase when the OTM call becomes ITM, but your short position is “covered” by the long stock. Also, you can secure a profit of 160.65 points. But your position will not gain more if the stock moves above 900, as the gains in the stock will be offset by the increase in the intrinsic value of the put option.
You may consider selling a mid-month contract. You will receive a higher premium, but you have to wait longer to make a profit. If you hold the stock in multiples of the allowable lot size, you can consider selling one contract of two different strikes based on the target price of the stock, for example, 900 and 930 at ICICI Bank.
What if the stock fell from its current level? You can close the position by selling your shares and buying the call. Or you can keep the position open until expiration.
If you do the latter, the losses (or loss of profit) on your stock will be mitigated by the call premium, as the put option will expire OTM.
Finally, what if the stock moves up but does not reach the target price at expiration?
The OTM call will expire, and the premium received for short selling the option will add to your profit if you sell the asset.
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