This article appeared in the June 2014 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
By Graham O'Brien, ASX
In last month's ASX Investor Update we discussed how options can be used to protect your shares. In the second part of our coverage on using options in your portfolio we look at selling (writing) calls, against stock you already own to generate an income stream over and above dividends.
Why do people write covered calls?
The covered call strategy is essentially a strategy for neutral to slightly bullish markets - you must be willing to sell your shares so therefore would only write calls over a stock you think will move sideways or slightly up.
The two main reasons people write calls over their existing shareholdings are:
1. Generating income
The covered call represents one of the few ways an investor can generate returns when the price of a share is static. It involves selling call options which means that you will be taking on an obligation to sell shares that you own at a predetermined price in the future.
For taking on this obligation you receive a premium. If the share price remains steady or falls, the option is not likely to be exercised and you keep the premium and the stock. Typically the strategy is constructed using options with four to eight weeks to expiry.
2. Partial protection against a fall in the price of the shares
The covered call is also a risk-reducing strategy. If the share price falls, the value of the shareholding will fall, however the premium income received may partly offset the fall.
Let us now look at an example and the steps involved.
Selecting the stock
First make sure you select a stock that you are willing to sell. Then make sure it is a stock that you you think will remain within a certain price range over the short term. Writing a covered call over stocks with significant price volatility (rising or falling), including potential takeover targets, may expose you to loss. See the price charts below.
Selecting the price level you'd be happy to sell the shares
Just the same way as you'd make a decision on what price you'd place a limit order to sell shares in the sharemarket, think of the strike price at which you would like to write your options. Using the price charts from the previous page let's assume the resistance level is $25.00 whilst there is support at $20.00. This fictitious stock (XYZ Limited) is currently trading at $22.00. For an explanation of support and resistance levels look at the ASX charting library. You would choose the $25.00 strike price to write calls because you don't think the share price will break through the resistance level.
Selecting the expiry month to write
You must remember that writing options assigns an obligation to you. Therefore, to reduce the risk of fluctuations in price, an options writer will generally look to reduce the amount of time they are potentially obligated. Most covered call sellers will look to options 4-8 weeks until expiry. Using this criterion, if you were looking at this trade in June then you would consider July expiring options.
Let's assume you own 500 shares in XYZ. You have now decided to sell call options at a $25.00 strike expiring in July. You advise your broker to sell: 5 XYZ June $25.00 Calls
Let's say this option is trading at $1.00. Each option contract covers 100 shares of the underlying stock, so the premium received is $500.
At expiry, if the share price is below $25.00, the option taker (person who bought the option from you) is not likely to exercise the option, as XYZ shares could be bought more cheaply on the market. The option would therefore expire worthless. You would keep the premium income ($500) and any other income like dividends you receive from the shares.
If the share price at expiry is above $25.00 the option is likely to be exercised, meaning you will have to sell XYZ shares at $25.00. This obligation applies regardless of how far above the exercise price the stock has risen. The effective sale price is $26.00 (the $25.00 strike price plus the $1.00 premium).
If the shares rise above $26.00 you would have been better off holding the shares without selling a covered call.
What's your risk?
There are 3 key risks to using the covered call strategy:
- The stock continues to fall - if the share price slumps, the fall in the stock's value may exceed the premium received. If XYZ fell below $21.00 then you would make a loss as the $1.00 premium you earned is overtaken by the loss from the stock falling from its original price of $22.00.
- The stock rallies strongly - as the call writer you are obligated to sell stock and therefore give up any additional profits above the strike. If XYZ rallied beyond $26.00 you would have been better off not writing the covered call.
- The call option is exercised early - buyers of American style call options have the right to exercise any day up to and including the expiry day. This often happens the day prior to a stock going ex-dividend. As a shareholder that wants to receive dividends you should either refrain from writing calls that span dividend dates or look to write European style options that can only be exercised by buyers on the expiry day.
How to get started using options for protection
Step 1: Get informed
ASX will be holding a series of seminars in June designed specifically for investors looking to learn more about options.
Alternatively you may want to look at ASX's suite of free online classes that run you through the basics of options right through to detailed courses on both of the strategies we will cover.
Step 2: Set up
Setting up an account to buy put options is no more involved than to buy and sell shares. Find a broker. Read the ASX explanatory booklet your broker will send you. Fill in the necessary account opening forms and you will have the infrastructure to buy options.
About the author
Graham O'Brien is Manager, Equity Derivatives Sales, ASX
Equity options has information the features, benefit and risks of these products.
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