Covered call writing without the stock

If you write covered call options but are limited to the lower priced stocks you own 1,000 shares in, like Telstra, Fosters and Qantas, then this strategy is worth considering. It could allow you to trade the stocks you want without having to fund the purchase of 1,000 shares of $30 stocks like NAB or CBA. You can employ this strategy without using a margin loan facility or instalment warrants.

What you do is buy a deep in the money call option for at least 6 months out and you can then sell a call option against it each month for income. Your sold call option doesn't incur a margin as they are "covered" by the bought call at the lower strike price.

Let's have a look at how this works with a CBA example.

Trades 13/4/04 - Stock $32.38
Buy 1 CBA Oct $29.00 call option @ $4.03
Sell 1 CBA Apr $32.50 call option @ $0.29
                                       Net Debit $3.74

The aim is to have the sold option expire worthless and write another option in May.

For the purpose of this example assume that the stock price of $32.38 and the Implied Volatility of 11.5% are the same after April expiry.

The key thing to note here is that the Oct $29.00 call is expensive but it is actually made up of $3.38 of intrinsic value and $0.65 of time value. But remember that with covered call writing, time decay will be beneficial to the trade. In this instance you have a bought option that will be negatively affected by time decay, however as time decay is greatest in the final month of an options life, the sold option will decay at a faster rate than the bought option. The premium earned on the April option is low as it was written half way through the month.

You could expect around $0.43 of premium for the May $32.50. If the stock was to remain around the strike price at October expiry then you will be able to sell the bought option for intrinsic value and the income you have earned will offset the loss of $0.65 in time value on the $29.00 call - a handsome profit! If you get exercised on the sold call you can enter the market to buy the shares to deliver or you can exercise the long October call. Generally it is better to purchase the stock in the market and sell the call, than exercise a call that still holds time value.

If you were not exercised and were able to write a new option each month for the duration of the strategy up to and including October it would provide a very attractive return, especially considering that the initial outlay was only $3,740. This would be an unlikely result and investors need to make sure their expectations are not too high when entering this trade.

Benefits of the strategy

  • No margin as the written option is covered by the bought option at a lower strike price
  • Smaller outlay than purchasing the stock outright, hence less risk.
  • Time decay occurs on the sold option at a faster rate

Downside of the strategy

  • If the stock fell then you would lose money on the in the money option just as you would with holding the stock. Of course the stock has an unlimited life whereas this strategy is limited to the expiry chosen for the in the money call.
  • The stock rallies and you get exercised requiring you to deliver, if the shares are purchased in the market, the transaction costs for the buy and the exercise could be considerable and cut into premium income
Disclaimer
The information contained in this email is for educational purposes only and does not constitute financial product advice. ASX does not represent or warrant that the information is complete or accurate. You should consider obtaining independent advice before making any financial decisions. To the extent permitted by law, no responsibility for any loss arising in any way (including by way of negligence) from anyone acting or refraining from acting as a result of this material is accepted by ASX.