Writing an at-the-money call option

This example shows how writing an at-the-money call option can deliver you income in a neutral market and provide you with limited protection in the event of a fall in the share price.

Assumptions

The following assumptions are made:

  • you are geared to 70 per cent
  • you are paying 8.75 per cent on the borrowed funds
  • your marginal tax rate is 48.5 per cent (includes Medicare levy)
  • implied volatility in News Corporation options is 42 per cent
  • gains/losses on both the call option and the underlying shares are taxable at your marginal rate
  • any losses are tax deductible against other taxable gains

Please note that income tax and/or capital gains tax provisions may apply to your options transactions. You should consult your professional adviser regarding the taxation consequences of your options trading.

Transaction costs such as brokerage are not taken into account.

Example
Assume you own 1000 shares in The News Corporation (NCP). It is 19 December and the stock is trading at $16.00. You believe that over the next month or so NCP will continue to trade around present levels.

You write an NCP Jan 1600 Call for 90c. By writing this option you accept the obligation to deliver your NCP shares for $16.00 at any time on or before the option’s expiry date of 25 January if the taker exercises the option. For this you receive the premium of 90 cents per share ($900 for the one option contract).

If your view is correct, and at expiry the share price is $16.00, you have increased the returns on your shareholding as shown in the following table:

Premium income $ 0.90
Funding cost of shares $(0.10)
Net income $ 0.80
Tax on net income $(0.39)
Net income after tax $ 0.41
Yield over option's life (annualised) 49.36%
After tax yield (annualised) 25.42%

Of course the share price may not remain at current levels.

The following table shows your position for various share prices at expiry of the option. In each case, the profit/loss on the shares must be taken into account as well as the option premium received. The table also shows your position had you not written a call option.

Closing Stock Price $15.00 $16.00 $17.00 $18.00
Capital gain/loss on shares $(1.00) $ - $ - $ -
Premium income from call $0.90 $0.90 $0.90 $0.90
Funding cost of shares $(0.10) $(0.10) $(0.10) $(0.10)
Total return $(0.20) $0.80 $0.80 $0.80
Total return (after tax) $(0.10) $0.41 $0.41 $0.41
If Option Had Not Been Written
Capital gain/loss on shares $(1.00) $ - $1.00 $2.00
Funding cost of shares $(0.10) $(0.10) $(0.10) $(0.10)
Net gain/loss $(1.10) $(0.10) $0.90 $1.90
Net gain/loss after tax $(0.57) $(0.05) $0.46 $0.98

Writing an at-the-money call produces higher returns than simply holding the stock if the stock falls, remains steady or has a limited increase in value. If NCP is below $16.00 at expiry, the option will expire worthless, and the premium serves as income and to compensate at least partially for the fall in value of your shares.

However, you gain no benefit from any increase in the stock price above the option’s strike price. If the stock is above $16.00 at expiry, your written option will be exercised and you must sell your stock at $16.00. Including the premium received, your effective sale price is $16.90. If the stock moves up strongly, say to $18.00, your profits will be less than if you had kept your shares uncovered.

For this reason, writing an at-the-money call is usually regarded as a suitable strategy for neutral markets. If you believe the share price may increase a little, writing an out-of-the-money call option may be more appropriate.