A covered call is normally used when you have purchased a stock or an index and then the price has come down. Therefore you want to reduce your average cost of holding without endangering your profitability. How does a covered call work? You buy the futures on the USD-INR because you expect the dollar to strengthen. You will use the covered call when you expect the dollar to strengthen marginally. Let us see the table below how it works.

Buy Futures

72.00

Prem

N.A

Strategy

Covered Call or Average Cost Reducer

Sell OTM Call

73 Strike

Prem

0.30

Buy 72 futures and Sell 73 call

Break Even

Cost is reduced by premium received

Price

Buy Futures

Call Strike

Call Premium

Break Even Cost

ITM / OTM

P/L on Futures

P/L On Call

Overall P/L

68.00

72.00

73.00

0.30

71.70

OTM

-4.00

0.30

-3.70

68.50

72.00

73.00

0.30

71.70

OTM

-3.50

0.30

-3.20

69.00

72.00

73.00

0.30

71.70

OTM

-3.00

0.30

-2.70

69.50

72.00

73.00

0.30

71.70

OTM

-2.50

0.30

-2.20

70.00

72.00

73.00

0.30

71.70

OTM

-2.00

0.30

-1.70

70.50

72.00

73.00

0.30

71.70

OTM

-1.50

0.30

-1.20

71.00

72.00

73.00

0.30

71.70

OTM

-1.00

0.30

-0.70

71.50

72.00

73.00

0.30

71.70

OTM

-0.50

0.30

-0.20

72.00

72.00

73.00

0.30

71.70

OTM

-

0.30

0.30

72.50

72.00

73.00

0.30

71.70

OTM

0.50

0.30

0.80

73.00

72.00

73.00

0.30

71.70

ATM

1.00

0.30

1.30

73.50

72.00

73.00

0.30

71.70

ITM

1.50

-0.20

1.30

74.00

72.00

73.00

0.30

71.70

ITM

2.00

-0.70

1.30

74.50

72.00

73.00

0.30

71.70

ITM

2.50

-1.20

1.30

75.00

72.00

73.00

0.30

71.70

ITM

3.00

-1.70

1.30

75.50

72.00

73.00

0.30

71.70

ITM

3.50

-2.20

1.30

76.00

72.00

73.00

0.30

71.70

ITM

4.00

-2.70

1.30

76.50

72.00

73.00

0.30

71.70

ITM

4.50

-3.20

1.30

77.00

72.00

73.00

0.30

71.70

ITM

5.00

-3.70

1.30

In the above case of covered call the investor is moderately bullish on the strengthening of the dollar. Hence they have bought USD-INR futures at Rs.72 and sold a 73 strike call at Rs.0.30. The break even cost for the covered call will be Rs.71.70 because your cost of the long futures gets reduced to that extent by the amount of premium. Below this level of 71.70 your losses are unlimited so this strategy should not be used when there is downside risk in the currency. On the upside, your profits will get limited at the point at which your call option is sold. In the above case, the trader has a maximum profit of Rs.1.30 which consists of Rs.1 as gap between the strike of call and futures and Rs.0.30 received as premium on the call. Here are a few key inferences that you can draw from this above table.

· The breakeven point is arrived at by deducting the premium of the call option to the cost of the futures purchased. Below this point we can unlimited losses below the level of 71.70. The downside is open in this case and hence you need to be cautious.

· This strategy is a good strategy to help you make money on the moderate strengthening of the dollar or the weakening of the rupee. However, at the same time your risk of dollar weakening below 71.70 is an open risk for you.

The question is what would have happened had we sold a 74 strike call option (premium of 0.05) instead of a 73 strike call option. What will be the trade off in this case? Let us check it out.

Buy Futures

72.00

Prem

N.A

Strategy

Covered Call or Average Cost Reducer

Sell OTM Call

74 Strike

Prem

0.05

Buy 72 futures and Sell 74 call

Break Even

Cost is reduced by premium received

Price

Buy Futures

Call Strike

Call Premium

Break Even Cost

ITM / OTM

P/L on Futures

P/L On Call

Overall P/L

68.00

72.00

74.00

0.05

71.95

OTM

-4.00

0.05

-3.95

68.50

72.00

74.00

0.05

71.95

OTM

-3.50

0.05

-3.45

69.00

72.00

74.00

0.05

71.95

OTM

-3.00

0.05

-2.95

69.50

72.00

74.00

0.05

71.95

OTM

-2.50

0.05

-2.45

70.00

72.00

74.00

0.05

71.95

OTM

-2.00

0.05

-1.95

70.50

72.00

74.00

0.05

71.95

OTM

-1.50

0.05

-1.45

71.00

72.00

74.00

0.05

71.95

OTM

-1.00

0.05

-0.95

71.50

72.00

74.00

0.05

71.95

OTM

-0.50

0.05

-0.45

72.00

72.00

74.00

0.05

71.95

OTM

-

0.05

0.05

72.50

72.00

74.00

0.05

71.95

OTM

0.50

0.05

0.55

73.00

72.00

74.00

0.05

71.95

OTM

1.00

0.05

1.05

73.50

72.00

74.00

0.05

71.95

OTM

1.50

0.05

1.55

74.00

72.00

74.00

0.05

71.95

ATM

2.00

0.05

2.05

74.50

72.00

74.00

0.05

71.95

ITM

2.50

-0.45

2.05

75.00

72.00

74.00

0.05

71.95

ITM

3.00

-0.95

2.05

75.50

72.00

74.00

0.05

71.95

ITM

3.50

-1.45

2.05

76.00

72.00

74.00

0.05

71.95

ITM

4.00

-1.95

2.05

76.50

72.00

74.00

0.05

71.95

ITM

4.50

-2.45

2.05

77.00

72.00

74.00

0.05

71.95

ITM

5.00

-2.95

2.05

In the above case of covered call the investor is above moderately bullish on the strengthening of the dollar. Hence they have bought USD-INR futures at Rs.72 and sold a 74 strike call at Rs.0.05. The break even cost for the covered call will be Rs.71.95 because your cost of the long futures gets reduced to that extent by the amount of premium. Below this level of 71.95 your losses are unlimited so this strategy should not be used when there is downside risk in the currency. On the upside, your profits will get limited at the point at which your call option is sold. In the above case, the trader has a maximum profit of Rs.2.05 which consists of Rs.2 as gap (74 – 72) between the strike of call and futures and Rs.0.05 received as premium on the call. Here are a few key inferences that you can draw from this above table.

· The breakeven point is arrived at by deducting the premium of the call option to the cost of the futures purchased. Below this point we can unlimited losses below the level of 71.95. The downside is open in this case and hence you need to be cautious.

· This strategy is a good strategy to help you make money on the moderate strengthening of the dollar or the weakening of the rupee. However, at the same time your risk of dollar weakening below 71.95 is an open risk for you.

· How does it differ from the previous case where 73 call was sold. You are able to take your profit range higher by selling 74 call but you also reduce your breakeven on the downside and thus it becomes more risky.

Practically, when do you use this strategy? For example, if you expected the dollar to strengthen and bought USD-INR futures and if the dollar weakened instead then you can keep selling higher call options that will expire out of the money so that the premium earned by you can reduce the cost of the long futures position in your case.