One of the cardinal rules of investing is to ring-fence your goal-based portfolios from your trading portfolio. That is, you should not use assets earmarked for your goal-based investments for trading gains. This week, we discuss how some traders violate this rule and what you can do to prevent yourself from doing so.
The cover
Covered call is a strategy of going long on an underlying and shorting the near-month out-of-the-money (OTM) calls on the underlying. Comb the Internet and you will find that covered call is listed as an income-generating strategy; you earn option premium every month as your income without your shares getting called away. And you can close your short calls before expiry when it becomes in-the-money (ITM) as the underlying climbs up.
This lure of earning income every month has made several traders short OTM calls against shares in a portfolio setup to achieve life goals. Even then, these trades will not violate the cardinal rule if you close the short ITM call at a loss instead of delivering the shares against the short position at expiry.
But to avoid a situation of having to align your goal-based investments with your trading portfolio, you could use surplus cash to buy Nifty ETFs. You can buy Nifty ETFs whenever you believe the Nifty Index has overreacted to the downside — preferably after five to seven red large-bodied candles. Or you could setup an SIP on Nifty ETFs with the surplus cash. Note surplus cash refers to investments that are not earmarked towards any life goal. You can short OTM Nifty calls against long Nifty ETFs.
You must consider two factors before setting up the position. One, the number of Nifty ETFs you hold must be in multiples of the permitted lot size for the Nifty calls — 25 for one contract. And two, you must identify a clear overhead resistance level and short the strike immediately above it. The objective is to short a call option that has a high probability of ending OTM at expiry.
Note that the short call will gain from loss in time value (time decay or theta). The time value is high, the greater the time to expiry. But greater time to expiry also makes the short position risky because there is so much time for the option to become ITM. So, you must trade-off greater time value and the risk of the option becoming ITM. An optimal time to short is 10 days prior to expiry. You should close the position before the option expiry.
Optional reading
You will be exposed to the risk that the short call will become ITM. Your strategy then would be to close your short call and your long ETFs. The objective of pairing the round-trip is to ensure that the loss from your short call is offset by the gains from the ETF. Your long position in the Nifty ETF is exposed to downside risk.
The author offers training programmes for individuals to manage their personal investments