Everything you wanted to know about the covered call for profit taking
Last week we compared the replacement strategy to the protection sell strategy as a way to take profit on an underlying position. This week we are discussing how you can use a covered buy strategy to take profit from your underlying position.
A covered call option involves short selling a higher exercise call against your underlying position. The goal is to bypass a strike that is likely to expire out of the money (OTM). Therefore, a covered call option typically involves short selling a call option that is one exercise above the resistance level of the underlying.
But our goal here is to take profits on the underlying. Therefore, you should sell a call option that is closer to your price target. The goal is to let the option expire in the money (ITM) so that you deliver the action against the short buy position. This strategy will only work if you have the inventory in multiples of the lot size allowed for options.
For example, if you want to make short calls on ICICI Bank to take profit on the stock, then you should have 1375 stocks or multiples thereof. The strategy works best if you have enough stocks that shorting a call option contract helps you lock in profits on 50% of your underlying position. In the case of ICICI Bank, that would mean having 2,750 shares.
You need to short sell the next month option, as the intention is to pull out the stock as soon as possible to lock in profits. It would be optimal to short the call when the contract has at least two weeks due; this would help you capture significant time value on the option.
Suppose you short sell the November 900 call on ICICI Bank at 16.65 points. If the stock closes above 900 when the contract expires, you must deliver 1375 shares at 900 per share. Your total profit will be 2.2 lakh (160.65 points multiplied by 1375), assuming you bought ICICI Bank shares at 756. Note that the call premium is added to your profit.
What happens if you close the position before the expiration? Suppose that 15 days before the contract expires, ICICI Bank approaches 900. You can close your short buy position by buying the option. The option could be worth 26 points. Your profit would then be 134.65 points. Indeed, a loss of 9.35 points on your short call reduces the profit on your underlying.
Alternatively, you can keep your buy position short until expiration even if the stock moves above the strike price. Your margin requirement will increase when the OTM call becomes ITM, but your short position is “covered” by the long action. Also, you can lock in to a profit of 160.65 points. But your position will not gain more if the stock goes above 900, as the stock’s gain will be offset by the increase in the intrinsic value of the short option.
You may want to consider shortening the interim month contract. You will receive a higher premium, but you will have to wait longer to take profit. If you are holding the stock in multiples of the allowable lot size, you may want to consider short selling a contract of two different strike prices depending on your price targets for the stock, for example 900 and 930 on ICICI Bank.
What if the stock drops 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 the expiration.
If you do the latter, the losses (or loss of profit) on your stock will be amortized by the call premium, because the short option will expire OTM.
Finally, what if the stock goes up but doesn’t hit your price target at expiration?
The call will expire OTM and the premium received for short selling the option will increase your profit if you sell the underlying.
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