Covered options are a way to take in premium without the risk of unlimited exposure associated with naked selling (writing options).It also allows you to maximise directional trading whilst reducing yield loss when making an incorrect judgement on the markets.
Our trader decides that USD/GBP is a buy at 1.51 and has a target price to sell at 1.5250. He would buy the currency pair future at 1.51 and sell the 1.5250 calls for the next expiration, ideally within the next two weeks as this is when maximum decay occurs in respect of time value on options. Lets assume that the options are sold for 50 pips. with all going to plan the futures price reaches 1.5250 on expiry day. Our trader makes 150 pips profit on the futures and also makes 50 pips from the options.
The same trade is placed and the market fluctuates around the entry point. The target price is not reached but the trade does not get stopped out. Assuming the view is still positive, the options expire worthless taking in 50 pips profit. Our trader would then sell the 1.5250 options for the following expiry, once again taking in 50 pips of premium. It is possible that with more time until expiry that more premium could be achieved but in this scenario this would be offset by a decrease in volatility.
The market drifts off and the stop is activated incurring a loss of 50 pips. The call options would have devalued and we can assume that we then buy these back for 30 pips taking a 20 pip profit on the calls. The overall trade is a loss but the cost of this losing trade has been reduced.
one critical data is released causing the market to rally sharply to a level of 1.5550. When the options expiry date is reached our counter-party would exercise their right to be long of the market at 1.5250 leaving us short at that level. However, as we are already long of the underlying at 1.51 we lock in a profit of 150 pips plus the 50 pips premium on the initial sale of the options.When taking a bearish view on a product the process would be mirrored with one minor difference. Assuming our trader predicts cable to sell off from a proce of 1.51 to a target of 1.4950. He would short the underlying at 1.51 but this time he would sell the 1.4950 puts.
The decision process for instigating a trade is based on a combination of certain indicators combined with reversal patterns using candlestick charting methodology.For this product example we would use currency futures and options as these are traded on the same exchange so there is a vastly reduced margin call for this type of trade. This means that there is a significant reduction in leverage and cost on initial investment.
The target and stop placements would obviously vary depending on the volatility of the chosen product. However, the ratio of 3/1 would proportionately apply i.e the profit target would always be at least 3 times greater than the stop placement.This strategy also works very well on a longer term basis for equities.
A good example of this is when the banking sector took a serious devaluation but eventually found a base. The sector did not recover quickly meaning that a portfolio of these stocks would have returned very little yield for some time. However, if options were sold in proportion to the underlying stock holding, a far greater yield would have been achieved. With equities we would only