Covered Call Possibilities for week June 30

The Nifty has fallen by almost 200 points this week. This is roughly 5 percent. The bear market continues throughout the world.

Covered call writing is best done in a stable, bullish environment. The setup involves bying shares and writing a call against the owned shares. The calls provide a premium which act as a hedge against a minot decline in share values, should this happen. If share prices incrase or remain stable, the trader makes money by some gains in the share price and by keeping the call premium.

If prices go up, which is the desired action, the trader is fully protected from losses in the written call, since he owns an equivalent number of shares which act as a hedge.

The risk starts if share prices start falling. To some extent the decline is protected by the call premium. But any excessive decline in prices will see an erosion in capital since the premiums will not be enough to cover the losses.

Such excessive declines usually occur in a bear market. We are in such a market now.

By fully understanding the risks involved and the current market scenario, we can determine if at all there are possibilities for covered call writing, and the stocks where this may be possible.

Here are a few rules to follow when planning a covered call strategy:

1. Purpose: The objective is to earn between 3% to 5% on a setup in one month, or less.
2. Investment: The covered call strategy requires the purchase of equity shares. Buying a stock future is NOT suggested. The idea is to acquire shares at lower than market prices, if prices fall. If you use futures instead of equity shares, the strategy is destined to fail.
3. If share prices begin rising, the value of your shares will increase. If you are getting 3% to 5% in the trade, you should exit the trade and take your profits.
4. If prices start falling, immediately switch to a defensive strategy. The objective should then become protection of capital, not profits. The startegy then is to buy back the call sold earlier, and sell lower strike price calls. This will fetch some additional premium to reduce the loss in share price.

Based on these rules, we have identified a few covered call setups for the week starting June 30, 2008. Since the market remains bearish, there is inherent risk. If prices fall, you should be prepared to become the owner of these shares. This is a fair method to acquire equity shares at a lower than market price.

Suggestion #1. Nagarjuna Fertilisers [cmp: 37.45, Lot Size: 3500]
Technical Outlook: fertilisers have broken out of a multi year consolidation. The stock is in a correction after a big rally to 90. There is support between 34 – 36, and then at 30.

Buy 3500 shares @ 37.45

Sell 1 call strike price of 40 @ 3.1

The buy sell prices are based on the last traded price. These will change on Monday, or whenever you set up the trade.
Break even: 34.35. Below this price, the trade will lose money. See point 4 above for trade management.
Maximum profit: If share price is at Rs 40 or above on expiration day, the trade will give Rs 6.65 per share, i.e. a return of 17.75% on the investment made in the shares. This does not take into account the investment required for margin on calls sold.

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