Question on covered call writing

Anant Pal Singh

Sir, i want to do covered call. For this i am planning to buy shares in equity ( equal to F&O lot size ) and sell ATM call at the start of every month. Can you suggest some good shares for this strategy. How much return it can give monthly? Is it a good strategy ?

Answer

Covered call writing is a good strategy to earn a steady income from the stock market. Here you are writing an ATM call while simultaneously taking a long position in the underlying stock.

The profit on the short call is guaranteed irrespective of whether the stock goes up, down or is rangebound.

What is the risk?

The only risk in this strategy is the risk of downside move in the underlying stock. Depending on the technicals of the stock, the loss can be notional if you are holding it long term as all the ups and downs will get nullified. But if the stock is in a long term downtrend, then it is a risk as stock may lose 50-70% of value and the option writing income may not be enough.

So to minimise downside risk, it makes sense to write calls where the stock is rangebound or trending up.

But this strategy may call for a lot of funds. Reason is a stock may gain 20% in a month in which case, the margin you have given to the exchange may not be enough. Since you will suffer MTM losses on a daily basis, you will need to fund your margin account on a regular basis.

Note that you are not incurring a loss on the trade as the position is already hedged but the exchange will not consider the delivery trade as a hedge for a derivative trade.

What returns to expect?

This is a function of implied volatility of the stock. This (fear) is highest in falling markets or in violent corrections and I have earned 4-5% in a month here (Tata Steel, Hindalco etc). As markets stabilise and the IV drops, the returns drop down to a more sedate 2-3%. In safer stocks like Reliance, returns are even lower.

Which stocks to write calls in?

Look at stocks where downside risk is minimal as this is the only risk in this trade.

So look at stocks which have just started rallying or a near long term supports. A good example is SBI, TATA STEEL. And the IV for both these stocks is around 40% which is very good.

Taxation... get some professional opinion in this as option writing income will be speculative income while gain in stock will be trading / investment gains. Tax rates will change depending on holding period.