Writing an out-of-the-money call option

This example shows how writing an out-of-the-money call option can deliver you high returns if your option is exercised, and income if the share price remains flat or falls.

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, or possibly a little higher.

You decide to write the out-of-the-money NCP Jan 1700 Call.

By writing this option you accept the obligation to deliver your NCP shares for $17.00 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 50 cents per share ($500 for the one option contract).

Writing an out-of-the-money option gives you greater protection from exercise than the at-the-money option, but the premium you receive is smaller. If the option is exercised, you will realise a higher net sale price for your shares than you will by writing the at-the-money call. If the share price remains steady or falls, your return is lower than from the at-the-money option.

If at expiry the share price is $16.00, your returns from this strategy are as follows:

Premium income $ 0.50
Funding cost of shares $(0.10)
Net income $ 0.40
Tax on net income $(0.19)
Net income after tax $ 0.21
 
Yield over option's life (annualised) 24.70%
After tax yield (annualised) 12.72%

 At expiry, the share price may well have moved from its current level.

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) $ - $ 1.00 $ 1.00
Premium income from call $0.50 $0.50 $0.50 $0.50
Funding cost of shares $(0.10) $(0.10) $(0.10) $(0.10)
Total return $(0.60) $0.40 $1.40 $1.40
Total return (after tax) $(0.31) $0.21 $0.72 $0.72
 
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 the $17.00 call produces higher returns than simply holding the stock if the stock falls, remains steady or has a moderate increase in value. If NCP is below $17.00 at expiry, the option will expire worthless, and you benefit from the premium income.

If the stock is above $17.00 at expiry, your written option will be exercised and you must sell the stock at $17.00. Including the premium received, your effective sale price is $17.50. However, this is the most you can receive for your shares while your call option position remains open.

Writing an out-of-the-money option provides you with some protection from exercise in the event that the share price rises during the life of the written call option. If you are confident that the share price will remain around current levels or even fall a little, writing an at-the-money call option may be a more appropriate strategy.