Last week, we compared replacement strategy with protective put strategy as way to take profits on an underlying position. This week, we discuss how you can use a covered call strategy to take profits on your underlying position.

Shorting calls

A covered call involves shorting a higher strike call against your underlying position. The objective is to short a strike that is likely to expire out-of-the-money (OTM). Therefore, a covered call typically involves shorting a call option that is one strike above the resistance level for the underlying.

But our objective here is to take profits on the underlying. Therefore, you should short a call option that is closer to your price target. The objective is to let the option expire in-the-money (ITM) so that you deliver the stock against the short call position. This strategy will work only if you have the stock in multiples of the permitted lot size for the options.

For instance, if you want to short calls on ICICI Bank to take profits on the stock, then you should have 1,375 shares or multiples thereof. The strategy works better if you have enough shares such that shorting one contract of a call option helps you lock in profits on 50 per cent of your underlying position. In the case of ICICI Bank, that would mean having 2,750 shares of the stock.

You must short the near-month option because the intent is to have the stock called away sooner than later to lock in the profits. It would be optimal to short the call when the contract has at least two weeks to expiry; that would help you capture sizeable time value on the option.

Suppose you short the November 900 call on ICICI Bank at 16.65 points. If the stock closes above 900 at contract expiry, you must deliver 1,375 shares at 900 per share. Your total profit will be 2.2 lakh (160.65 points times 1,375), assuming you bought ICICI Bank shares at 756. Note that the call premium adds to your profit.

What happens if you close the position before expiry? Suppose 15 days before expiry of the contract, ICICI Bank moves closer to 900. You can close your short call position by buying the option. The option could be worth 26 points. Your profit would then be 134.65 points. This is because a loss of 9.35 points on your short call reduces the profit on your underlying.

Alternatively, you can carry your short call position till expiry even if the stock moves above the strike. Your margin requirement will increase when the OTM call becomes ITM, but your short position is “covered” by the long stock. Also, you can lock in to 160.65-point profit. But your position will not gain further if the stock moves above 900, as the gain in the stock will be offset by the increase in intrinsic value of the short option.

Optional reading

You can consider shorting the middle-month contract. You will receive a higher premium, but you must wait longer for taking profits. If you hold the stock in multiples of the permitted lot size, you can consider shorting one contract of two different strikes based on your price targets for the stock, say, 900 and 930 on ICICI Bank.

What if the stock declines from its current level? You can close the position by selling your shares and buying the call. Or you can keep the position open till expiry.

If you do the latter, the losses (or loss of profit) on your stock will be cushioned by the call premium, as the short option will expire OTM.

Finally, what if the stock moves up but does not reach your price target at expiry?

The call will expire OTM, and the premium received for shorting the option will add to your profit if you sell the underlying.

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