Trading Strategies (Options) – 1
In this series I am going to discuss various trading (investment) strategies using Options. In this first post of this series, I would like to discuss about the COVERED OPTIONS POSITIONS.
1. Covered Short Call
This sometimes referred to as a buy/write strategy. It is constructed by combining a long underlying position with a short call position.
Example
An investor is long 1000 XYZ Plc shares. Current share price is 207. He sells an ABC Plc 225 call for a premium of 11 (each contract is for 1000 shares).
Let us now analyze the outcome at expiry.
1) If the share price is unchanged at expiry, the option is abandoned. The investor keeps the premium, thereby creating a position return on investment.
2) If the share price falls, the premium helps to cushion the drop. The investor is hedged to the extent of the premium. If the drop is less than the premium, he is still better off. If the drop in the price is greater than the premium, the investor losses the excess above the premium.
Summary
The motivation of this strategy is to enhance returns in a stagnant market and, at the same time, to partially hedge a long underlying position (stock or futures contract). If the market remains static, an investor will enhance the return on the asset, since he has received the option’s premium and it will expire unexercised.
In a falling market, the premium reduce the loss, but will not provide a true hedge. In a raising market, overall gains will be limited, since the call will be exercised and any further gains above the strike price will not be realized, since he no longer owns the asset (underlying).
Risk/Reward Summary
- Loss : Unlimited once the underlying asset (stock or futures contract) price falls below the break-even-point.
- Profit : Limited to premium received (if the option expired unexercised).
- Maximum Profit : Premium received + (Strike Price – Cost of acquisition)
Trading Tip
Anybody holding a stock for a long period of time can generate a consistent income (options premium) every month by writing (short) Out-Of-The money (OTM) calls.
In the next post we shall discuss another covered options position i.e., Covered Short Put
