WRITING COVERED CALLS
Writing (Selling) Call Options when you already own the underlying is called writing covered call options. It is against writing Naked options which can have unlimited risk.
HOW WRITING COVERED CALL OPTION WORKS
As discussed earlier a Call is the right to buy an underlying asset above a certain price, and before a certain date. Now only the liquid calls in India are the near month expiry which means that there are, at most, 30 days for the calls to expire. If you eliminate holidays roughly it comes to an average of 20 trading sessions per month. Now lets understand the number of ways the covered call seller benefits.
]. If the options volatility reduces, he makes the difference of the volatility premium.
2. As the time to expiry reduces, he makes money on the time value.
3. If at expiry the price is below the strike price,, he took the entire premium as profit, no questions asked.
The above advantages of the option call writer/seller turns into disadvantage for the call buyer. The call Buyer thinks that he is minimising his risk because he has paid a fixed amount and that is all he is risking. Actually though, he makes money only if the price of the stock rises very strongly. Previous experiences shows that markets and stocks trend only 25 % of the time. So Generally the call writer/seller makes most of the money frequently. WORLD WIDE DATA SUGGESTS THAT ONLY 15% OF THE OPTIONS ARE AC TALLY EXERCISED. The reason behind this is very simple, markets don’t trend most of the time. It is only during these relatively rare trending periods that option buyer make money, the rest of the time when markets consolidate or turn sideways, it is the option writer who makes consistent profits. A month is simply too short a time for an option buyer to make money except in a raging bull market.
If the stock starts trending upwards, how is option writer protected? Well, he is protected because he OWNS THE UNDERLYING. In a delivery settled system he w’ould deliver the stock but in India’s cash settled system he needs to pay only the difference between the strike price and the stock price prevailing at the end of the month* which he can do by selling the stock he owns. So the upside risk is covered because of his ownership of the underlying. If the covered call writer writes a call all twelve months of the year in a good market and makes 4% per month, it is a return of 48% per annum. Generally the call is not exercised till it is deep in-the-money. However when it is exercised, the trader can simply write a new, higher call option.
But, always remember, the covered call writer may lose if the stock starts declining sharply. This is the situation in which the cover call writer can lose. This risk can also be reduced by a technical analyst wrho chooses his covered call stocks properly. The call writer can thus greatly reduce the risk of writing calls. In reality, therefore the call buyer is not the one reducing his risk. Actually, he is the one that is taking all the risk and is giving the cal I seller a consistent, high return on his stock holding.You should write covered calls only in a sideways, mildly bullish, or an extremely bullish market. If the market environment is very bearish where every stock is getting slaughtered to half its value, writing covered calls may not do you any good. In such situations, it would be advisable to wait till the market completes its sharp falls and goes into a sideways mode in forming a basing formation. These bases often take six month to form, sometimes it could take as long as two years. Investors and traders can then again start writing covered calls once the market bottoms out.
THE IMPORTANCE OF STOP LOSS IN WRITING COVERED CALLS
As the covered call only protects the covered call writer to the extent of the premium, it is extremely important that traders keep some kind of a stop loss in case the stock starts declining in a major way, such as breaking of crucial supports, breaking down from a range, some unexpected fundamental news, etc., Generally speaking, in most cases You should not keep the stock if it starts to give back the entire premium and/or starts breaking down supports. If you do not want to get rid of the stock then buying puts based on the chart patterns may not be a bad idea. But the key idea is never to get stuck on a sinking ship in the hope that a covered call will bail you out in the end.
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