Options: Countering Inaction

Being a “Bania” by birth and even by heart, “interest” is something which intrigues me a lot. Because of that it becomes very important to understand macroeconomic indicators. This in turn helps in building a market view from a very different perspective. A lower interest rate regime is favourable for equity markets, which we are seeing across the globe. While growth is clearly a concern in most of the countries around the world, stock markets are near new high, with interest rates staying benign or a quantitative push by the central banks. Clearly, central banks are playing a much more important role in world economics.

My early days in stock market started before the introduction of derivatives in India. Being long term investor we had times (especially when markets were weak) when the stocks would give little or no dividends as well as capital gains. I always felt that we had a huge opportunity cost lost at that time. Also, there were times when a stock would run into a rough time and one was sure that it would not perform well for next few quarters, the only way out than was to hold it and wait for things to improve.  Here also there was opportunity cost involved.

However, with the introduction of derivatives this issue has been plugged. The strategy we are discussing is “Covered Call“. This is not restricted to traders, even investors can use it effectively. When I talk about investors, these are not just direct equity players, but even Mutual Fund investors.

So, if one has a view to hold a stock which is not expected to do well or rather stay range bound he can go ahead and sell out of the money (OTM) call options on it. This can be a 5% or 10% OTM option. As you move from 5% OTM strike the liquidity will get thinner, so creating large positions can be slightly difficult.

Incase, the stock slips lower, you are further protected to the extent of the premium you have received. Also, you have the option to ladder down the short call strike. On the other side if the stock moves up you are not going to lose money as the loss on the short call will be covered by your long underlying position.

The premium is generally between 1% -0.5% for a 5%-10% OTM strike, indicating a risk free yield of 6%-12% (not considering the interest on the margin locked). So for an underlying which is expected to stay range bound this covers up the opportunity cost and keeps giving some returns regularly.

For, Mutual Fund holders, one can do this against the type of funds they are holding; Largecap, Midcap or Smallcap. As per the fund type the Index will be used for option writing.

Even traders can use it for their trading positions. So, if one buys an underlying in futures or cash, against that he can write an OTM Calls. The strike can be the target or the near target levels. While the Premium realized can be used for funding the Stop Losses.

Any kind of inaction is something which hurts a Long Underlying holder. Options has the most effective and efficient tools to counter that. So, whenever the underlying is in inactivity one can look at Covered Calls. To know more, attend our FREE Seminar

Happy Trading.

Cheers!!!