Crime Today News
A covered call involves a long position in an underlying and a short position in an out-of-the-money (OTM) call on the underlying. What if you substitute a futures contract for the underlying in the covered call? This week, we discuss when and how to use a futures contract against a short OTM call without incurring the rollover costs.
Rolling shorts
The position consists of a near-month long futures contract and a near-week short OTM call. The position involves continually shifting into a short OTM call till its expiry matches that of the futures contract. We will refer to this position as a rolling switch trade. Typical switch trade involves using futures instead of an underlying. We use the term “rolling” in a broad sense to mean shifting the short option position from near-week to next-week, and not necessarily to the same strike.
Suppose you go long on the near-month Nifty futures and short on the near-week Nifty call (April 9 expiry). When the near-week call expires, you roll the short position to the next-week Nifty call (April 17). The rolling process will end when you move the short position to the April 30 expiry, as that coincides with the expiry of the April futures contract. The objective is to capture time decay from the short OTM calls while continuing to hold the long futures position. You could still capture a near one-to-one movement in the futures contract if the Nifty Index were to move sharply closer to expiry.
There are several factors to consider. Your view on the Nifty Index must be bullish; for the premium from the short calls may not be enough to protect losses from long futures position should the Nifty Index decline sharply. Also, you must review the overhead resistance level before you roll your short call position to the next week. Suppose the Nifty Index trades at 21910 and you short the near-week 22300 call. If the Nifty Index were to move to 22250 on option expiry, you may choose to shift to the 22500 next-week call. Note that keeping the short option till expiry will help you capture the entire time decay as gains, as time value must become zero at expiry. That said, you can rollover the short position prior to expiry if the implied volatility of the next-week call is significantly higher.
Optional Reading
The rolling switch trade is not an alternative to the covered call strategy. To be comparable, you must continually rollover your long futures position too. But rollover costs can be high, as the futures curve is typically upward sloping- the longer the expiry, the greater the futures price. You should consider the rolling switch trade when you are bullish on the Nifty Index but expect the price target to be achieved closer to expiry to also gain from the option’s time decay. So, you may not have a reason to carry a switch trade every month.
(The author offers training programmes for individuals to manage their personal investments)
Published on April 12, 2025
📰 Crime Today News is proudly sponsored by DRYFRUIT & CO – A Brand by eFabby Global LLC
Design & Developed by Yes Mom Hosting
