This article appeared in the June 2011 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.

Strategy provides income, and protection over existing shares.

Photo of Graham O'Brien By Graham O'Brien, ASX

Last month ASX Investor Update discussed how options can be used to protect shares. But the most popular options strategy is writing calls against shares you already own to generate an income stream over and above dividends.

The covered call strategy is essentially for neutral to slightly bullish markets. You must be willing to sell your shares and therefore would only write calls over those you think will move sideways or slightly up.

(Editor's note: ASX has a new standard contract size of 100 shares per contract for the single-stock ETO market.  Learn more about this important change.)

The two main reasons people write calls over their existing shareholdings are:

1. 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, thus obligating you to sell shares already owned at a predetermined price in the future.

For this obligation you receive a premium, almost like an extra dividend on a shareholding. If the share price remains steady you keep the premium and the shares. Typically, the strategy is constructed using options with four to eight weeks to expiry.

2. Protection against a fall in the price of the shares

The covered call is a risk-reducing strategy. If the share price falls, the value of the shareholding will fall. However, the premium income received at least partly offsets the fall.

Three key considerations

1. Selecting the stock over which to write calls

Make sure you select those that, first, you are willing to sell, and second, you think will remain within a range over the short term. Immediately eliminate those that are a potential takeover target and any you believe may rise or fall significantly.

2. Selecting the price level at which you would be happy to sell

Just as you would make a decision on what price you would place a limit order to sell shares, think of the strike price level at which you would like to write your options. Take Commonwealth Bank (CBA) as an example. The chart below shows a resistance level at $55.00. In May, CBA was trading at $53.00. You could choose the $55.00 strike price at which to write calls.

 CBA line chart - Nov 2010 to May 2011

CBA line chart - Nov 2010 to May 2011

Source: ASX

3. Selecting the expiry month

You must remember that writing options assigns an obligation to you. Therefore, a smart options writer will look to reduce the amount of time they are potentially obligated. Most covered call sellers will look to options four to eight weeks until expiry.

A worked example

Let us assume you own 500 CBA shares and have decided to sell call options at a $55.00 strike expiring in June. You advise your broker to sell to open :

Five CBA June $55.00 Calls

On May 6, with CBA trading at $53.00, this option was trading at $1.00. Each option contract covers 100 shares so the premium received was $500.

At expiry, if the share price is below $55.00, the option taker (the person who bought the option from you) will not exercise the option, as CBA shares could be bought more cheaply on the market. The option would therefore expire worthless. You would keep the premium income ($500).

If the share price at expiry is above $55.00, the option will be exercised, you will have to sell CBA shares at $55.00. This obligation applies regardless of how far above the exercise price the shares have risen. The effective sale price, however, is $56.00 (the $55.00 strike price plus the $1.00 premium). The return, if this trade is exercised, is 5.6 per cent over 48 days.

If the shares rise above $56.00 you would have been better off holding the shares on their own without selling a covered call.

Risks to consider

There are two key risks with the covered call strategy:

  1. The shares continue to fall - if the price slumps, the fall in value may exceed the premium received. If CBA fell below $52.00 you would make a loss. (This happened in May).
  2. The shares rally strongly - as the call writer you are obligated to sell shares and therefore give up any additional profits above the strike. If CBA rallied beyond $56.00 you would have been better off not writing the covered call.

About the author

Graham O'Brien is a business development manager at ASX.

From ASX

Using covered calls reduces the risk of a share falling while providing an income stream. If you want to learn more about options there are some great resources on the ASX website.

The views, opinions or recommendations of the author in this article are solely those of the author and do not in any way reflect the views, opinions, recommendations, of ASX Limited ABN 98 008 624 691 and its related bodies corporate ("ASX"). ASX makes no representation or warranty with respect to the accuracy, completeness or currency of the content. The content is for educational purposes only and does not constitute financial advice. Independent advice should be obtained from an Australian financial services licensee before making investment decisions. To the extent permitted by law, ASX excludes all liability for any loss or damage arising in any way including by way of negligence.

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