Strategy - COVERED CALL WRITING
- Strategy Outlook
Investor thinks that the market will be rise moderately in the short-term.
- Implementation of this Strategy
A futures contract is bought and an at the money call option with similar expiry
is sold.
- Upside Potential
Limited to the difference between 'strike + premium received' and 'futures buying
price'. For maximizing returns with corresponding increase in risk, a deep-in-the-money
call should be sold.
- Downside Risk
Unlimited after the 'futures purchase price - premium received' level, which should
be taken as a stop loss level. The other alternative in that case will be to cover
the call sold and selling of a fresh in-the-money call. Another alternative in limiting
risks could be the simultaneous buying of a deep-out-of-money put which helps in
protecting from a sudden fall in prices. However this will raise the stop loss level
by the amount spent in buying the put.
- Margin
Yes, but off-setting applies.
- Remarks
There is a risk of loss if the futures price falls below the stop loss level as
arrived by above.
When to enter into a covered call writing?
The covered call writing is entered into when there is moderate bullishness about
the underlying.
The fast time decay in case of near month option could also be a temptation to enter
into this strategy.
- Warning:
The strategy has substantial risk attached if the prices fall below the stop loss
level.
There is a risk of loss if the futures price falls below the stop loss level as
arrived by above.
Strategy - LONG STRADDLE
- Strategy Outlook
Investor thinks that the market will move significantly but is unsure of the direction.
- Implementation of this Strategy
A call option and a put option with similar strike prices and expiry are bought.
- Upside Potential
Unlimited. The movement in either direction has to be substantial in the first place
to cover the premiums paid on both the options and thereby to generate profits.
- Downside Risk
Limited to the extent of premiums paid on both the legs. Maximum loss occurs when
the underlying's price is similar to the strike price of the call and put option
bought on expiry.
- Margin
No
- Remarks
This strategy is advisable when heavy volatility is expected in the underlying but
the expected direction is uncertain. This strategy should be used with caution in
case of stocks already witnessing heavy volatility, where the premiums traded will
already be on a higher side thereby restricting the profit potential.
When to enter into a long straddle?
Long straddle is used when heavy volatility is expected but the surrounding uncertainty
has made the direction uncertain.
In the converse case where the volatility in the underlying is expected to be low,
one can go for a short straddle i.e., sell a call and a put with similar strike
prices and expiry.
- Warning:
The strategy may not be profitable when the volatility in the underlying price is
already high resulting into high premiums, which raises the break even point on
both the sides.