Previously in this column, we discussed why setting up a covered call strategy on the Nifty Index is different from that on individual stocks. To recap, you must use either Nifty ETF or Nifty futures for the long leg on the covered call because Nifty Index is not a tradable asset. Given the rollover cost associated with futures contracts, using Nifty ETF appears better. This week, we continue this discussion with respect to the number of ETF units you should hold to initiate a covered call strategy.
Delta vs margins
Typically, the number of shares to hold in your demat account should be in multiples of the permitted lot size. The argument is that you must hold the covered call till option expiry to derive the maximum benefit; if the short call expires worthless, you keep the option premium as your gains. If the short call expires in-the-money (ITM), you will be required to deliver the underlying shares, which you will have in your demat account. Your net gain then will be the strike price of the call less the cost of the shares plus the option premium.
When you set up a covered call on the Nifty, you do not have to deliver the underlying shares constituting the index; the contract is cash-settled. So, we suggested that you could hold the permitted lot size times option delta times 100 if you are using, say, Nifty BeES to initiate a covered call on the index. The rationale for delta-adjusting the quantity is simple. The long position in the Nifty ETF is to protect (hedge) the short call from gathering losses should the Nifty Index move up sharply.
You must be mindful of two issues regarding delta-adjusting the quantity. One, an option’s delta changes as the underlying changes, captured by the option gamma. So, you may have to continually delta-adjust the quantity. But that has associated costs. So, we suggested that you assume a delta of 0.50, delta of an at-the-money (ATM) option, even though you would be shorting an out-of-the-money (OTM) option. The rationale is that you are likely to close the short option position when it gathers losses. This will be most likely when the strike is close to becoming ITM. And two, short calls attract margins. NSE will allow cross margin benefit only if you the pre-defined quantity of the ETF on the Nifty Index. In the case of Nifty BeES, you should hold 7500 units. Cross margins reduce the trading capital required to initiate a covered call.
Optional Reading
At the minimum, you must hold the delta-adjusted quantity of the Nifty ETF to initiate a covered call. It is best to hold ETF units required to avail NSE’s cross-margin benefits. The optimal way is to set up a systematic investment plan on a Nifty ETF, accumulate the quantity required to avail the cross-margin benefits and then initiate a short call against the ETF on a continual basis.
(The author offers training programmes for individuals to manage their personal investments)
Optimal way
To set up a systematic investment plan on a Nifty ETF, accumulate the quantity required to avail the cross-margin benefits, initiate a short call against the ETF on a continual basis
