Trading with options can give us exciting opportunities to make money from the markets in every market scenario. You can use call and put options to make money from rising, falling as well as neutral markets.

Normally traders are more comfortable in buying options since that gives them the chance of earning unlimited profits while keeping their losses limited to the premium that they have paid while buying the option. They shy away from writing (selling) options since it can potentially give them unlimited losses while keeping their profits limited to the premium they have received.

However, though writing options is considered to be highly risky, there are many ways in which you can earn relatively risk-free profits combining option writing with other strategies. The strategy that we will discuss today is one of those.

How to minimize the chances of a loss?

The best way to reduce your chances of a loss is to never opt for naked option writing. In other words, always write calls against another position that you hold in stocks, futures or options. In that case, even if the short call position gives you a loss, you will have the profits from the other position to cover the loss.

The strategy: Covered Call

Today we will be discussing how you can make money by writing Calls against a portfolio of shares that you hold. This is called a Covered Call Strategy. This strategy can be created by:

• Buying and holding a portfolio of shares
• Writing OTM Call options against those shares.

As you can see, this strategy involves selling Out Of The Money (OTM) options against a portfolio of shares. So, let us first understand what Out Of The Money options is.

Out Of The Money options

Out Of The Money (OTM) options are options whose current payoff is not profitable to its buyer. In other words, these options are not exercisable by the buyer.

A call option is said to be Out Of The Money when the spot price of the underlying is less than the strike price of the option

If you understand this concept well then you can make good profits by writing options.

Advantages of writing Call options against a portfolio

The Covered Call strategy has some distinct advantages and you can easily earn some good returns from the markets with it while taking a low risk. So let us understand those advantages now.

1. You will get your profits upfront

One of the biggest advantages of writing options is that you get the premium (which is your maximum profit possible) from the buyer when you enter into the trade. Hence you do not have to wait till the trade is squared off to get the profits.

If you are confident about this strategy working in your favour then you can go ahead and use this premium money to enter into other positions in stocks, futures and options.

2. Low probability of exercise

OTM options have medium to low chance of getting exercised if you choose the strike price carefully. Hence it is always advisable to write Deep OTM options that have almost no chance of getting exercised unless the markets make very sharp moves in a direction opposite to what you had expected.

OTM options are widely preferred by option writers because of this reason. If the option remains Out Of The Money on the day of expiry then it will expire worthlessly. So the buyer will not be able to exercise it and you will get to keep the premium that you had earned when you had entered into the trade initially.

3. Earn time value

Time value is an important component of the price of an option (premium) which loses value with the passage of time. Time value is the maximum at the beginning of the month. Then it starts to fall and becomes zero at the time of the expiry. It causes the option premiums to come down significantly

This decay of Time Value works in the favour of the option writers and hurts the option buyers. If you write an option and hold it for some time then you will notice that the premium will fall considerably making the option cheaper to buy. As an option writer, you will get to keep the premium to the extent of this fall and it adds to your profit.

4. Increased returns in addition to the equity portfolio returns

Writing a Call Option against a portfolio you hold is a great way to earn some extra returns in addition to the portfolio returns.

Thus, the total return you earn will be:

Profit from the increase in the value of the portfolio + the premium that you will earn by writing OTM call options.

Many traders use this strategy to earn returns from their portfolios of shares which they hold for the medium to long-term. You can also use this strategy to earn and almost risk-free return on the shares that you hold.

5. Safety:

As we mentioned earlier, writing Out Of The Money options is a relatively risk-free way of earning the premiums. Since the buyer will not be able to exercise these OTM options you will get the advantage of trading with a free mind as long as the markets do not make a sharp move against your expectations

Even if the markets move unfavourably, then in the worst scenario you will have to sell the equity portfolio that you hold, in order to compensate for the loss that you have incurred from the short Call position.

At Finideas we conduct classes where we teach Covered Call and many other option strategies with advanced software and decision support tools. If you want to learn how you can make money using futures and option, then feel free to browse our website www.finideas.com and get in touch with us to see how we can help you to master the markets and enhance your profits from the trades that you do.