Previously in this column, we compared covered call to a bull call spread. We later discussed when a covered call can be considered as an income strategy. This week, we look at why setting up a covered call on the Nifty Index is different compared from that on stocks.
Non-tradable asset
To set up covered call strategy on stocks, you should typically have shares in multiple of the options’ permitted lot size in your demat account. Then, you should short out-of-the-money (OTM) calls on the stock. But setting up covered call on the Nifty Index is different.
The index is not a tradable asset. So, you must go long on a tradable product on the Nifty Index or on Nifty futures. Going long on Nifty futures will require continual rollover and associated costs. Therefore, the optimal strategy would be to choose a Nifty ETF. That poses some challenges. The Nifty BeES, for instance, is priced at 1/100 of the value of the Nifty Index whereas the Invesco India Nifty 50 ETF is priced at 1/10 of the value of the Nifty Index. To set up a covered call, you should hold Nifty BeES (Invesco) that are 100 (10) times the option delta times the permitted lot size to sell one contract of an OTM call. Though index options are cash-settled, you need to delta-match the quantity of Nifty ETF with Nifty calls to protect (hedge) the short call from making large losses. One issue is that the delta will change as the Nifty Index changes. You could assume a delta of 0.50 to delta-match the Nifty ETF with Nifty calls. This would allow you enough room to protect your short call should the Nifty Index move up sharply; note that the delta of the short call will increase when the underlying moves up.
Also, Nifty ETFs may not move one-to-one with the underlying index. This is because the demand for ETFs comes primarily from retail traders whereas the demand for stocks constituting the Nifty Index also comes from institutions and professional traders. As with any strategy involving short call positions, the short strike must be above an overhead resistance level. The objective is to increase the chances that the short call will expire worthless, which will happen if the Nifty Index fails to break above the resistance level.
Short strike
As with any strategy involving short call positions, the short strike must be above an overhead resistance level
Optional Reading
The objective of a covered call strategy is to earn income by capturing option premium through time decay. The optimal time to set up a Nifty covered call is during the expiry week. The absolute time-decay capture will be small, given the low time value closer to expiry. But the chances of capturing time decay will be high, as the time value must race to zero at expiry. The strategy could generate sizable gains if you initiate the short call position continually through the year, especially during weeks when you believe the Nifty Index is likely to remain range-bound.
(The author offers training programmes for individuals to manage their personal investments)
