Consider covered calls as an income generation strategy in bear markets

When life gives you lemons…it’s a good time to make lemonade.

And if the markets seem bearish while you’re holding on to some good long-term stocks…it’s the time to consider covered calls.

A fairly basic strategy, selling calls on long-term holdings, which you have no intention of selling, is a smart way to generate some additional income when markets seem gloomy.

A covered call involves selling an out-of-the-money (OTM) call option on shares that one holds.

But what could guide you with regards to timing such trades?

You could derive a short-term view, based on technical analysis. Implementing this strategy makes sense where one sees major resistance and the price is unlikely to cross that in the near future.

Let’s look at a recent example from our markets.

Towards the end of July, technical trends of SBI had clearly bearish implications.

After forming double tops at 374, the scrip started moving downwards, forming lower tops and lower bottoms. This signalled a trend reversal. Then, on 30^th July, the price closed below its major support of 333 at 327, forming a bearish engulfing pattern.

On the upside, the scrip had formed 3 consecutive tops at around 347 levels that will act as a major resistance, which it was unlikely to cross in the near future.

Now, suppose you held 4000 shares of SBI in your portfolio, which you had no intention of selling. They were quoting at Rs 332 in the cash market on 31^st July 2019.

With a bearish technical view of the stock and 347 as an immediate major resistance level on the upside, you could have executed a covered call strategy and gained some income from it.

On 31^st July, SBI 29 AUG 2019 345 CE (Call option of August expiry) was quoting at Rs. 8.45 and the lot size of SBIN is 3000.

By selling one lot of SBI 29 AUG 2019 345 CE at the premium of Rs.8.45, you could have gained a maximum profit of Rs.25,350 (i.e. 3000 x 8.45). The approximate margin amount on SBI is Rs.1,50,000.

Here’s how that would have played out…

On expiry, i.e. on the 29^th August, SBI closed at Rs 274.50 in the cash market, which was Rs.57.50 below its rate on 31^st July. As a result, the 29 Aug 2019 345 CE expired worthless.

You would have enjoyed the entire premium of Rs.25,350 as profit from this trade.

There are a few things you must keep in mind when you decide to sell covered calls…

1. You face the risk of a notional loss – If the price crosses above the breakeven price (i.e. the strike price plus the premium received; in our illustration, 345 + 8.45 = 353.45) then you could start incurring a loss on the option you have written. But this is only a notional loss for you as the value of the shares you hold will go up by the same amount. So, for instance, if SBI had closed at 355 in the spot market on 29th August 2019, you would have incurred a loss of Rs. 4,650 (Rs 1.55x3000) but the value of the stocks you hold in your portfolio will increase by the same amount.

2. On the expiry date, square up the outstanding position in the market if you want to avoid physical delivery of the stock, which is the exchange’s default option for outstanding contacts in the derivatives market.

3. Remember, while selling / writing a call option, you have to pay the margin money, which is pre-defined by the exchange.

We’ll soon be talking about another strategy - Protective Puts - which you may find useful when you think your stocks could go into a free fall.

You May also like: Can you benefit from Market Volatility using a simple, low risk derivative strategy?

Disclaimer: 

We, Ventura Securities Ltd, (SEBI Registration Number INH000001634) its Analysts & Associates with regard to blog article hereby solemnly declare & disclose that:

We do not have any financial interest of any nature in the company. We do not individually or collectively hold 1% or more of the securities of the company. We do not have any other material conflict of interest in the company. We do not act as a market maker in securities of the company. We do not have any directorships or other material relationships with the company. We do not have any personal interests in the securities of the company. We do not have any past significant relationships with the company such as Investment Banking or other advisory assignments or intermediary relationships. We are not responsible for the risk associated with the investment/disinvestment decision made on the basis of this blog article.