The main reason is typically in such times, volatility is very high, news flow is not in favor of the market in general, more than price uncertainty, your mind actually is under lot of stress, just looking at what is going on. And it is in such times that you need strategies that will lower your overall risk in terms of your positions. And even the psychological stress part, you need to keep that in check. So this is where I feel that covered call writing comes into play, it's extremely helpful to create a strategy that will limit your risk on the downside, and you would be in a position still to try and anticipate bottom in the market http://casinoslots-sa.co.za/entropay.
Now for using covered call writing as a hedge, you need to select the right instrument. The first requirement in my opinion is that of, let's say stock futures or index futures, it should be highly liquid. Now usually futures whether it is index futures or stock futures, they have good volumes. But you need to worry about the options volumes because you may have seen this stock futures would be having good volumes, but when it comes to option volumes, options are not that liquid. So which is where some of the stocks in F&O segment in our market, they don't have good volumes in option segment, so make sure you check this first that whichever stock or index features you are selecting, they should be highly liquid. You should also have a basic understanding of what options is and the basics of options which is how Delta and Theta impact option pricing. Now in case you don't know about how Delta and Theta are impacting your options price, you won't understand much that I'm gonna explain in subsequent slides, and the next video. So I would actually request you to go back and see the video on part one, part two, part three, and options trading where I have actually explained these concepts. So I've put the link to those videos in the description box below. So look at the chart here. Now two things that make it difficult to identify bottom in the market is volatility, and the impact of that volatility on your trading mindset. Now look at how this chart is trending down, look at the frequent gap openings that you are getting, sometimes price opens lower and rallies during intraday. So this particular scenario becomes extremely difficult to trade. If you are attempting to buy at this point or this point or any of these given points without a proper hedge in place, then let me tell you 90% of the time you will exit the trade because the trading mindset is such when we see prices moving lower. So in case you're attempting to catch the next up cycle, and you're somewhere here or you're somewhere here, this covered call writing strategy comes in very handy because once you create a covered call writing strategy at this place or at this place, and even if the price goes on to make low, a new fresh low or the next few days, you would still be able to generate some returns or actually limit your overall losses. So that directly has an impact on your overall trading psychology, and you intend to stay much longer in that position, rather than if you don't hold a properly executed hedge for your positions. So I will just outline some steps for you that will help you create a proper hedge for your position. The first step is to identify the right instrument. Make sure that for your particular instrument, there is high volume in options segment. The second step is to actually open up your covered call riding position that is you need to enter the stock or stock futures or index futures, depending on what you are trading, take a note of spot price. Third step is strike price selection. When it comes to call writing, this should be one to two strike prices away. So hypothetically, let's assume you want to enter X Y Z, the spot price is 10,000. Your call option selection that is strike price selection should be one or two strike prices away which is 10100 or 10200. Step four, take a note of your options premium that you will be receiving while you're writing call options, and take a note of options Delta and options Theta value. Step five, you need to calculate how much you stand to lose if price of your stock futures or index futures falls by 1%, 2%, or 3%. Step six, you need to put a rupee value to the potential losses that is 1% lost, 2% loss, or 3% loss, you need to define it in terms of rupee that is how much rupee or how much dollars you're going to lose if the price were to fall 1%, 2%, 3%, that is your stock stock futures or index futures. And last step would be to use options to hedge or offset at least 70% of potential losses that can come about in case your asset will fall by 1% 2% 3% or more.
0 Comments
Now, again if this part is slightly confusing, I will repeat again, how this strategy is traditionally executed is that traders look at it from a monthly income generation point of view, and they go out and buy a stock and sell a higher strike price call option to benefit from the same. What I am suggesting that is an ideal way to execute a strategy that is you do it on a stock that you already hold for the long term in your portfolio, it's already delivering returns for you. And over the short term, you don't anticipate any strong movement in the stock, and this is where you go and execute this strategy because while the long term is very bullish for the stock, in the short term or let's say the medium-term, stock is moving lower, and you want to generate some income over it.
Now through this, what you would do is you would continue to hold the stock for the long term, get dividends over it. You can even reinvest those dividends. And just in the short term when the stock is not doing well, you will use this covered call strategy, call writing strategy to generate some additional income while your stock is moving in a very tight range or let's say it's just mildly bullish. So one of the key things that you will require heading ahead is the art of instrument selection in this particular strategy. Now in my opinion, instrument selection plays a pivotal role when it comes to getting success out of this strategy, because out of your long-term portfolio, you will first need to divide your stocks into high Beta and low Beta stocks. Now low Beta stocks are less volatile stocks, and you should be targeting those stocks specifically. These particularly belong to the Defensive Sectors that is Consumer Goods, FMCG, IT, Pharma, and other such sectors. The reason why you need to avoid high Beta sectors and stocks for this strategy is because you don't want excessive price action either on the downside or upside which is typically associated with high Beta stocks and a high Beta sectors. Now once you are done with instrument selection, I'll just list out some key points in the next slide which you have to follow in order to execute this strategy. So the first thing that I'll tell you is stay away from covered call writing when you have earning season on the way. Now, usually in earning seasons, there are some strong surprises that is positive surprises in the market and there are some negative surprises. In each case, stock would actually respond in a violent manner because you do see that in earning season, sometimes stocks do open up, let's say 5% to %10 up or even 5% to 10% down. Now for this strategy, you should typically not want such sort of volatile movement, and which is why in earning season, you should just stay away from covered call writing strategy. When it comes to holding period, you should be willing to hold the stock over a period of three to four years at least. The main reason is that a stock takes time to have a up cycle and a down cycle. Now this whole cycle that is a cycle from where stock goes from the bottom to the high point, this plays out over a period of four to five years. So in case you want to execute this strategy for long time, you need to stick with those stocks only which you don't intend to sell or the next three to five years. In up cycle, stocks will automatically deliver returns for you because you're holding equities. But when the down cycle comes and the stock starts to consolidate or let's say fall little, you can sell calls every month to minimize your losses on portfolio and even to generate some extra income for yourself. The last thing that I want to focus upon is quality. Always focus on low debt and high RE companies in this particular strategy. This information on low debt and high RE is available on screener.in I'll just leave the link in the description box below. So let me just repeat what I have summed up here. The way to generate income with covered call writing strategy, first you need to hold a stock at least for three to five years which is already delivering returns to you. When stock is in an up cycle and you're identifying momentum in it, you should not be selling calls because the stock or the index would automatically deliver returns for you. But when it comes to down cycle or a stock which goes under consolidation, you should be looking to sell calls every month in order to generate additional income or offset the losses that you are seeing in your portfolio. So the next segment of the strategy that I wanna focus upon is using covered call writing to identify bottom in the market. Now trying to identify bottom in the market is not easy, it's really difficult even the professional struggle to do so. So I will just get down to some basic calculations for you. So we will calculate maximum profit, maximum loss, and the break-even point. Now maximum profit in this particular strategy is defined with this particular formula that is strike price plus the premium received minus the stock purchase price into the quantity that you purchased. So, just recollect, the strike price was 65, premium received was three, and the stock was purchased at 60 rupees. So maximum profit that you can get in this strategy based on what example we have created is rupees 800.
Now what about maximum loss? Maximum loss is defined as stock purchase price minus the premium received into the quantity purchased. Now what would that be? 60 was the stock purchase price, three rupees was the premium that we received, so that is 57. 57 into the into 100 that is the quantity we traded, that is 5700. So what would be the break-even point according to this strategy? It would be stock purchase price minus the premium received, that is 60 minus the three rupee premium that we received, so break-even point is 57. Now I will just put out the risk profile chart for you. Now as we saw in the previous slide, 57 actually becomes the break-even point, the maximum loss that we can undertake is 5700, that is if the stock goes to zero. Now there is one thing I wanna tell you here, that just recollect that we actually bought the stock at 60 rupees 100 quantities. So we had a net outflow of 6000 rupees, right? But if you look at this risk profile chart, the maximum loss shown here is only 5700. The reason is, because you have written the highest call in this strategy, you have lowered your risk essentially by rupees three. So the key takeaway from covered call writing is that it reduces the risk of an open underlying position, that is if you hold a simple long position in index or a future, or let's say a stock, covered call writing essentially reduces the open risk. In this particular case, the risk was reduced by rupees three per share, right? But you also need to remember one thing that your potential profit will also be capped. Look at this stage, it's mainly because once your stock starts getting higher than your call strike price, you start to lose money on that. So, your underlying stock position would actually make money, but your call position that you have written, that would actually begin to show losses. So which is why you would ideally want your stock to stay in a particular range. In this particular case, had the stock fluctuated between let's say 55 or 62, you would have realized maximum gains for this particular strategy. So I hope the basics are very clear. In case you have any confusion, just go back to this particular slide where I've explained this covered call strategy with an example. So now we will be moving to a section of covered call writing, how to use this as an income generation strategy with your existing long term investments. Now covered call writing, when it comes to as a strategy, the thing that you'll hear first is that it's an excellent strategy to generate consistent monthly income. Now while this is true, I think you do need to reach a certain level in terms of trading experience before you can do this on a consistent basis. Now what typically traders do is that in order to generate some monthly income, they typically buy a stock and then they go on and sell a higher strike price call in order to benefit from price remaining in a range. Now in my opinion, this is not the smartest way to do because by this particular method, you are not allowing time and volatility to be on your side. Now just think of it, if today you go and buy a stock and then sell one strike price higher call option, you are just expecting too much from the stock that it is not supposed to move till expiry which may be 20, 15, 10 or 8 days away. A better way to do this is to do it with your existing long term portfolio. That is, in order to execute this strategy, you would require a stock in your portfolio that is already delivering about 20% or more returns to you. Now in the short term, you should not be expecting that any major bullish move should happen in the stock, and this actually should preferably be confirmed on a chart. |
AuthorSimon Nulman ArchivesCategories |