Writing call options using instalments

Looking to leverage your option income stream?

Whether the market is flat or rising, you may be looking for opportunities and strategies to boost your returns. ‘Writing call options over instalments’is just one such strategy which typically combines writing call options with instalments that are lodged as collateral.  This way, you can potentially enhance your income stream in a flat to slightly bullish market plus benefit from the leverage effect of the instalments.

The key benefits that instalments can offer are based on the leverage effect. You can:

  • Write call options with less capital outlay, and 
  • Double the number of option contracts for the equivalent share investment, or 
  • Diversify and write call options over two stocks for the same capital outlay

Implementing the strategy

When writing call options there are generally two factors to consider:

  • Exercise price of the option - this reflects how bullish or bearish you are.  The more bullish on the stock the further the exercise price will be from the share price.
  • Expiry date of the option - this reflects the duration of your exposure to the option.

Which option you write will depend on your view of the underlying share price at expiry of the option. If the share price is above the exercise price at expiry, the option will be exercised and you will be obligated to sell your shares to the buyer of the option.  If the share price is below the exercise price you will retain the premium and the share.

In selecting the instalment there are generally two factors:

  • Gearing level - generally writers of call options use a gearing level of less than 65%, to cover the collateral requirements of the ACH
  • Expiry date of the instalment - generally the instalments expiry date will be beyond the options expiry date.  It is common for traders to use longer dated instalments when periodically writing call options.

Example

You are about to purchase 1,000 CBA shares and decide to a write call option over the CBA shares for the additional income stream.  With CBA's share price trading at $37.83, select a 2 month, $38.50 call option which is currently trading at 39 cents.

This strategy, buying shares and writing call options, will require significant capital outlay ($37,830) to implement.  As an alternative you could substitute the CBA shares for CBA instalments.  This would allow you to reduce your capital outlay while still receiving the same option premium.

In assessing whether to write call options over shares or instalments, you compare the results where at expiry CBA is trading below $38.50.  In this situation the call option will expire worthless and you will retain the stock/instalment and the option premium.

CBA shares CBA instalments
No. of shares/instalments   1,000 1,000
Buy price $37.83 $14.50
Cost of collateral $37,830 $14,500
Option income received - CBA/AUG/3850/Call    $390 $390
Profit (if option is not exercised)    $390 $390
Static return (if option is not exercised)    1.03% (390/37,830)     2.69% (390/14,500)    
Annualised return 6.2% pa 16.1% pa

The return on investment for using instalments as collateral is 2.69% compared to shares 1.03%. Using instalments as collateral allows you to reduce your capital outlay while enhancing your return on the capital invested.

If you continue to adopt this strategy on a regular basis (write call options every two months and approx. $1.00 OTM) you may generate a return of 16.1% pa using instalments.

Another attractive feature of using instalments in this strategy is the flexibility it offers.  You can diversify your option premium income across a number of different shares for the same capital outlay.  With the instalment only requiring a portion of the capital upfront you can purchase exposure in other shares other than CBA and write call options, further enhancing your income stream and yield. 

Remember, instalments will pass on the full dividend entitlement as if you held the fully paid share outright.

Main benefits of the strategy

  1. You can use the strategy to generate income by selling call options on a regular basis.
  2. Instalments compared to shares, allow you to enhance your income returns when writing call options. It enables you to more effectively manage your investment collateral.
  3. Premium earned on the written call option can potentially offset some downside share price risk.

Main risks of the strategy

  1. If the share price falls dramatically the call option premium received provides only limited protection. However, you will still be better off having written a call option rather than having simply held the shares uncovered.
  2. If the share price rises significantly above the option's exercise price you will forego the upside.
  3. If the option is exercised you are obligated to deliver the shares. If you have lodged instalments as collateral, it is uneconomical to exercise the instalments to deliver the shares. As an alternative you can purchase the shares on-market to meet your obligation.
  4. While you can potentially claim the pre paid interest from the instalment, it is an additional cost incurred.

Disclaimer
The information 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.