One can easily find books on options trading that claim covered options writing to be a sure shot way to money making.These kind of strategies look easy to execute and their failure seems almost impossible.A reader could easily believe what is being said about it but there is a doubt if he will ever be able to use this method.Here is my look on practical covered option writing on NSE for both calls and puts.
We start with the basics of this strategy,for example we first take covered call writing.This method argues that when you write an option you will get some premium for it.So without any outflow of funds you get a certain premium deposited.Now when you square the position off there has to be a downward move to make that call option lose value so that you can buy it back for a lesser price.The difference between short price and long price is your profit.They argue that due to time value factor of options premium options are bound to lose value and there will be a lot of chances for you to buy it back at lower prices.In case it doesn’t happen so then you have the stock ,of which you are selling the option, with you to offset the losses.We take example of RNRL here.Its one lot is 715o shares.If one has to write a covered call on it then one has to have 7150 shares in demat account.Then write a call option on it and get some premium paid.If the rnrl goes down in next days that call option will most likely be expire worthless so at the end of it one will have the difference of premium and 7150 shares of rnrl.
What is not mentioned about covered call writing is that there is margin involved.Each option written is taken as a futures lot position and similar margins will be charged on it.Normally there are two parts of margin namely span margin and mtm margin.These margins are fixed by sebi.In volatile markets these margin get very high.Our system is such that in volatile markets there will be a need to deposit higher margins on securities than in less volatile times.In our example of RNRL total margin including span and mtm at present is around 47% of the contract value.In absolute terms this margin will come to Rs.4,54000.These margins are instant outflow once you take a short position on options.Writing an option is like shorting an option.So the first hitch with covered options writing is that there is a big outflow of funds.Suppose you wrote one call option for a premium of 10 rs.So total inflow in you account will be Rs.71500.Only in highly favourable conditions this option will lose all its value and then you will be able to pocket all the premium.In most cases this will not happen so.Lets suppose options expired at Rs.1.Now you buy it back to square off your position and your net profit is now reduced to Rs.64350 (7150*9). The question here is that to earn Rs.71500 (maximum profit) who will put margins of Rs.454000? Books tell you that covered call writing doesn’t involve any outflow in the beginning which is possible only in books.In real time trading there is a big margin.So what one earned was a return of 16% which looks handsome but is not so.During the time this position is kept open one will be asked to meet the margin calls on mtm basis.
In case there is a wrong move.RNRL makes high points and doesn’t fall down.Then this call option you wrote will not lose value instead it will gain.Making the buying back difference thinner with each gain.To this, theory says option writer can sell his shares in the cash market to offset the losses from call premium.But it involves losing out a share which is earning good profits to offset a trade that made losses.Our derivatives market is not delivery based,it is cash settled.So there is no question of being assigned the notice of exercise.Covered call is called covered because the call write has the stock with him already.In our example of RNRL it means the writer has enough money to buy 7150 shares in cash market and put atleast Rs.454000 as further margins with the exchange.This will become a trade of around Rs.9,00,000.And on this trade there is the maxim possible profit limit.Losses are unlimited.In covered call writing or put writing losses are always unlimited.Profile size is fixed.In rnrl the maximum profit in our example is Rs.71500 on a total investment of Rs.9,00,000 approx.Which is a return of around 8%.
Considering that Rs.9 lakh is not a big amount for most traders one could argue why not put this money on a trade that has unlimited profit potential and limited loss.Like going long in options.What works in favour of covered call writing is that our market have short life options and there is a strong impact of time value in premium valuation.So if one is ready to put in this much money in one trade there are high chances he will benefit from covered call writing.Option writer has to take care of some basic things like writing a deep in the money or deep out of the money call as per his view on future status of that stock.Option writer should also check that there should be enough liquidity in the stock.This strategy certainly works but it is not the best thing to do.If one has a portfolio of Rs.10 lakh for option trading there are better things to do with it than going short.With that big a portfolio a return of 8% is not good.Its an excuse for avoiding better trades.