iCharts Discussions

[chaaru]

Dear All,

I would like to initiate a discussion on a simple method which can be used to earn a regular income month after month.

Assume that you are a long term investor. The typical approach is to buy a well known stock, like Infosys, and keep it with you for a long time. The only income you earn as long as you hold the stock is through dividends. The price of the stock may fluctuate wildly but the LT investor is not bothered as he has the holding power and is convinced about the long-term merits of the stock. However, you actually get the benefits only when you sell. As long as you hold the shares, your capital is blocked and your income is limited to the amount of dividend you receive.

I shall outline below a strategy which can convert this 'dead' investment into an active investment. This is a strateg called a 'Covered Call'. It is as old as the F&O markets but as far as I know, not many people use it to its fullest potential.

The credit for giving me clarity on this should go to Sri. J V Sagar.

Covered Call Methodology

A. instead of buying 200 shares of Infosys, you buy one lot of futures by paying the required premium. The premium is normally about 30% of the total value. Keep the remaining amount in a liquid fund to earn interest.

B. As soon as you buy the futures, sell 200 at-the-money calls. or slightly above-the-money calls. If you bought the futures at 2066, sell the 2070 call at say, 150. Your immediate income is Rs.30,000 on an investment of approx. 4lakhs.

C. Make sure that you sell the calls of an expiry month which is atleast two weeks away so as to maximise the premium received. If this is an expiry week, sell the next month calls.

D. Now let us assume that the price increases to 2100. Your gain still remains 30,000 + 800 ( from the four rupees capital appreciation, 2070-2066)+ Interest from the liquid fund. You lose out on the Rs. 34/- gain between 2066 and 2100. But it is not a loss as you were not going to sell the stock anyway.

E. Let us assume that the price falls to 2000. Your broker will demand the mark-to-market of Rs. 66 X 200=13200. Withdraw this sum from your liquid fund and credit to your broker.

F. This process of adjusting MTM will continue everyday. Therefore keep enough money in the margin account to take care of day-to-day fluctuations.

G. Post-expiry, Buy a fresh lot of futures and sell a fresh lot of calls.

What can go wrong?

1. Let us say the price continues falling. If the amount in your margin account falls below about 70% of your original investment, you will not be able to buy a fresh lot of futures. .As long as the price does not fall below 70% of your investment, you can continue to repeat this process month after month. Remember that you are earning nearly 8-9% every month and adding that to your margin account. Therefore if markets remain sideways or bullish for about 13-15 months, you can recover your money in this period.

2. You must be clear that this is a strategy to be used in a disciplined manner over 2-3 years. If there is a prolonged bear market, your investment may go way below the initial value. You must treat it as a long term investment and not get perturbed. The focus must be on ensuring that a minimum margin is always maintained and on deriving premium from the investment month-after-month.

3.. Stock futures can be very volatile. Remember Satyam? Therefore do not be tempted by the high premiums of Stock calls. It is better to buy index futures and sell Index calls as they are less volatile and hence safer.

So here's a nice way to build wealth. Hope you put it to good use. Good Luck and God speed.

[rj2900]

In this strategy, you have limited your profit which is a small amount of premium of call and opened floodgate for losses. Therefore buying of options as a tool to hedge futures is always a better strategy where you have limited your loss in the shape of premium and the profit could be unlimited.

[chaaru]

rj2900: This is not a trading strategy to get maximum profits. It is an investing approach which is almost risk-free. By investing a given sum of money, you can get upto 50-60% returns in a year which, I think by any standards, is a great return.

As an illustration, let us say you buy one lot of Nifty futures at today's price of 4600 and sell one lot of Sep 4600 CE at 166. To do this you will need a margin of max. 60k. Next you need to keep a margin for the fluctuations in the Nifty. For this we have to estimate the downside for Nifty in the next 6 months. Let us be very conservative and say that the downside is 1500 points from here. Let us keep a margin for this downside, which is 1500 x 50=75000. Therefore your total investment is Rs.135,000.

On investment of Rs.135,000, you have received an income of Rs. 166 x 50=8800 in the first month. Next month, on the same day, NF will be
at some other level, could be 5000 or 3600. At that level buy a new lot and sell a new call. You receive the next premium which will be approx. the same as what you have received this month. Repeat this process month after month and you will recover your money in approx. 15 months. Use the premiums accrued to write new covered calls and compound your returns.

You will be able to repeat this process as long as you have 60k in your margin account. And remember that with each passing month, you continue adding to your margin of safety because the premium adds to your margin account.

[Ravi_S]

Chaaru

Could you please explain how you get an income of 166*50=8800? Ideally lets say during expiry NF is trading at 4800, then the Futures lot would be at a profit of 200*50 = 10,000 Rs. What would ideally happen to th the options we shorted? Would it expire? If it expires then we would lose 8800 aint' it? Please clarify...

Regards
Ravi

[Ravi_S]

Hi Chaaru

Can you illustrate this with an example? Today NF is at 5108 and 5100CE is at 97.35, what would be your strategy?

Regards
Ravi

[nandasn]

Hi Charu,

Can we follow the same strategy for covered put i.e. sell put and sell Nifty Future?

Regards,

SANJEEV NANDA

[rksharma1091]

Can we follow the same strategy for covered put i.e. sell put and sell Nifty Future?

Regards,

SANJEEV NANDA
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this strategy will be profitable Nifty Future remains volatile