Many young traders desire to earn income by shorting options. The primary motivation is the understanding that many long trades lose money. As options trading is a zero-sum game, losses on longs translate into gains on shorts. This week, we discuss a trade initiated to earn income — covered call to capture time decay quickly. Strategically, we call this accelerated covered call.
Time decay trade-off
The maximum gain on a short call is the premium you collect when you initiate the trade. But capturing maximum gain requires you to keep the position option till expiry. Note that long call is a right, but short call is an obligation. And obligations require traders to post margins. The issue is that margin requirements on your short call will increase significantly at expiry. Also, your short call is exposed high risk, as the underlying price can increase sharply.
An alternative is to set up a covered call strategy. While the margin will remain the same, the strategy will remove the risk relating to underlying price movement. This is because the strategy involves going long on a stock and short an out-of-the-money (OTM) call. Two conditions are important for covered call to be gainful. One, the number of shares you hold must be in multiples of the permitted lot size. If you choose to set up this strategy on the Nifty Index, you could go long on the near-month Nifty futures or the Nifty ETF. And two, the OTM call you short must be preferably one strike above an important resistance level for the stock or the index.
But when should you set up the covered call position? Time value of money consists of two components — time to expiry and implied volatility. Now, the longer the time to expiry for an option, greater the time value. So, the more time to expiry for the option, the greater the absolute time decay. In contrast, the absolute time value of a call option during the expiry week (Monday through Thursday) will be small. The time decay will, however, be faster as the option must become zero at expiry. Also, the likelihood of a short call moving against you is less, the shorter the time to expiry. Therefore, you could consider shorting calls against an existing long underlying position during the expiry week. Hence, the name accelerated covered call.
Optional reading
In a covered call, the intention is to capture gains from time decay through the short call. The long stock protects against any adverse price movement of the underlying; for, the short call in such cases will gather large losses. The strategy is gainful if you short an OTM call against an existing long stock or index position. You must choose your underlying carefully. Typically, the underlying should have started its consolidation phase after an uptrend. Empirical evidence suggests most options expire worthless. But if the short call ends ITM, your underlying will be called away in a covered call strategy.
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