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Last
month we discovered a new way of investing with Exchange
Traded Funds (ETF's).
In the following article from the Montreal Exchange, we learn
more about Covered Call Writing, one of many different option
strategies.
We know that investor psychology strongly impacts fluctuations in the
financial markets. Investor psychology also changes the outcome of an
option strategy as its goal can differ depending on the investor. For
example, the choice of an option series over another can change entirely
the objective of a strategy. This is how investors can use the sale of
covered call options to protect their stock portfolios.
Writing covered call options consist of selling call options on shares
already owned in a portfolio. It can also be executed simultaneously
with the purchase of stocks. Covered call writers are mildly bullish
on the stock, or even neutral. Why? Because if the stock rallies, covered
writers (sellers) run the risk of selling their shares to the option
holders (buyers) who have exercised their right to buy at a price much
lower than the market price. Covered writers are prepared to take this
risk in exchange of the premium collected from the options.
Generally speaking, investors using this strategy seek to enhance the
return of their portfolio: they cash in the premium received for writing
the calls. In fact, Lawrence G. McMillan, President of McMillan Analysis
Corp., says that:
The strategy of owning the stock and
writing the call will outperform outright stock ownership if the stock
falls, remains
the same, or even
rises slightly. In fact, the only time that the outright owner of the
stock will outperform a covered writer is if the stock increases in
price by a relatively substantial amount during the life of the call
(Options
as a Strategic Investment, 1993, p. 34).
If the shares are trading exactly
at or below the option's strike price at expiration, the calls
will expire worthless. Investors
retain the
entire premium collected.The maximum profit is attained if
the stock price is slightly higher than the strike price:
Maximum profit = (strike price - stock
purchase price) + premium collected
However, in this situation, investors
will lose their shares to buyers who have exercised their option. Note
that the gains made with this strategy are always limited.
On the downside, the greater the stock declines, the greater the investors'
losses. However, losses on the stock position are reduced by the premium
collected from the sale of the option.
Maximum
loss = stock purchase price - premium collected
The above demonstration applies to written at-the-money or out-of-the-money
call options. But what happens to covered call writing when the option
is in-the-money?
Most of the time, protecting a stock position means buying put options.
However, some investors do not like to invest in a wasting asset that
might lose all its value if their bearish expectations do not materialize.
Writing in-the-money covered call options provides a larger protection
than writing out-of-the-money calls against a decrease in the stock price
because of the premium collected. Covered call writing becomes a hedging
strategy with in-the-money options.
Let’s take an example. You have bought 1,000 XYZ shares at $25.65
and you write 10 XYZ September 22.50 call options at $3.30. The premium
received serves as a cushion against a potential drop for XYZ. Contrary
to put option buying, the protection obtained when writing in-the-money
covered calls is limited to the premium.
Your lower break-even point is $22.35 ($25.65 - $3.30). On the upside,
your break-even point is $25.80 ($22.50 + $3.30). In other words, you
might incur losses on the overall position (stocks plus options) only
if the stock drops below $22.35 or rises above $25.80.
- XYZ trades at $20.00. The loss
on the stock position is $5.50 ($25.65 - $20.00). Even if the premium
received is $3.30, it is not sufficient
to cover such loss. The drop is too large.
- XYZ trades at $22.35
(your lower break-even point). The loss on the stock is $3.30 ($25.65
- $22.35). The premium received largely compensates
the loss incurred.
- XYZ trades at $25.80 (your upper break-even
point). You must sell your shares at $22.50. When accounting for
the premium received,
your final
sale price is $25.80. Once again, the premium of $3.30 offsets
completely your opportunity cost.
- XYZ trades at $31.00. You
are obliged to sell at $25.80 ($22.50 plus the premium received
of $3.30). However, you now experience
an opportunity
cost of $5.20 ($31.00 minus $25.80).
Writing in-the-money covered call options for protection instead
of buying put options is a sophisticated strategy and requires
continuous tracking
on the investors’ part. However, investors having neutral to
mildly bearish expectations will find the sale of in-the-money covered
call options an interesting and appropriate hedging strategy. And,
if their expectations are highly bearish, they can simply sell their
stocks instead of entering into a covered call write.
Please note that Option trading is not suitable for all investors and
there are risks associated to this type of investment. An Option Disclosure
Information Document stating the risks involved is available.
Interested in learning more about trading Options?
Sign-up for one of our free on-site seminars.
Click here for a list of dates and to register.
| N.B.
This bulletin is offered for information purposes only. Investments
must meet each investor's objectives. Disnat does not issue any recommendation
about a product or give out any opinion on the nature, suitability
or potential value of an investment or of any trading strategy. |
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