Delta hedging using covered call: a profitable and less risky investment strategy

Introduction All of us are familiar with the term option contracts, the derivative instrument which are quite common among active traders. In Indian market scenario index options are much popular compared to stock options with a few exceptions. The derivatives market is considered to be a dangerous one and most of the traders who have started trading in derivatives have burnt their fingers just because of not understanding the concept of „time value‟.Thus don‟t expect exceptional profits from options or futures contract but expect a reasonable gain of close to 25% per annum if you properly hedge your positions and then trade. The trades are executed through options contracts and that too an index option with the help of greek‟s of options like delta, theta gamma and vega. As has been pointed out by a number of researchers, the normally calculated delta does not minimize the variance of changes in the value of a trader‟s position. This is because there is a non-zero correlation between movements in the price of the underlying asset and movements in the asset‟s volatility. The minimum variance delta takes account of both price changes and the expected change in volatility conditional on a price change.

Objectives Delta is by far the most important hedge parameter and fortunately it is the one that can be most easily adjusted as it only requires a trade in the underlying asset. Ever since the birth of exchange-traded options markets in 1973, delta hedging has played a major role in the management of portfolios of options. Hedging using options can be different depending on the nature of the maturity of markets. For example both index options and stock options have enough depth in U S market but Indian market is still in a nascent state when we come to stock options. Implied volatility plays a major role in determining the fair value of an option contract and without understanding the impact of implied volatility options trading can be a night mare for most of the traders. One mistake that traders usually make is to ignore the implied volatility (IV) and only consider delta and theta. Option traders adjust delta frequently, making it close to zero, by trading the underlying asset. Arranging delta every now and then by initiating new trades would be a cumbersome process but the effort would be justified when it comes at a risk of 4-5%.The objective of this research paper is to find out ways by which a person who has knowledge about stock market can get decent returns. In this research paper I am trying to introduce a financial model based on index options and futures contract which is less risky compared to naked futures positions in the market.

Research Methodology Usually the problem faced by a layman is that he has enough money to spend on trading activities but there is no one to guide properly. A person who is trading in index options should have the basic knowledge of stock markets and need to have the patience to wait till the expiry of option contracts. While writing options one needs to wait until the time value gets eroded as that would be the profit element in writing options. A covered call would be a simple strategy of buying futures contract along with selling a call option. For example if we are long on nifty futures contract at 10200 we would hedge that long position by writing a call option either ITM(In The Money) or OTM(Out of The Money). When we sell an option contract some major questions that would come to the mind are which one to sell, when to sell, when to square off the position, how much investment is involved etc. The research paper analyses Black Scholes Model of option pricing and the pitfalls and differences associated with the original model. I have used secondary data consisting of option prices and the value of nifty futures for the same period. Technical analysis software Metastock is used for deriving the values of option greeks.

Results and conclusion
While trading delta neutral option strategies, there are times when the delta exposure becomes higher than what we initially planned for the trade. Perhaps the market has made a sharp move resulting in a sharp move of delta.The trader wants to stay in the trade, but is concerned that further moves will see losses start to accelerate. One solution is to use futures contract to temporarily hedge the delta exposure. This can be a short-term solution until things settle down. The markets would be in a trending mode only for a few months like 3-4 months and it would be in a range bound mode for rest of the months. Writing options can turn out to be a profitable investment strategy during this period as stocks would be stuck in a range and would hardly give any return.
As the objective clearly states traders often misunderstand options as instruments to trade either on the long or short side but they are actually instruments to hedge your stock or futures positions. As we all know once we hedge a position the major aim would be to protect the position rather than giving enormous profit. Thus the research paper focuses on developing a less risky but a profit generating strategy by using index futures and options. The same strategy of covered call using delta hedging can be used in stock options too once the stock options attain enough volume.Thus if a trader uses the time value of options wisely along with futures contract that can give the best possible result within a month‟s time. A well informed investor who is good in reading technical charts can easily make a return by using model of delta hedging strategy.