Covered calls case study

A covered call strategy involves selling a call option over security that is currently held (or being bought concurrently) in a portfolio in return for payment known as the ‘premium.’ The seller, or ‘writer’ of the covered call sets a price known as the ‘strike price,’ which represents the price at which they are prepared to sell the security. The seller can also set an expiry date, usually toward the end of the month, at which point the option expires. The strike price set by a seller, and the date the covered call expires, will impact the income or ‘premium’ they will receive in return.

On the expiry date, if the underlying security trades below the nominated strike price, the sold call position will expire worthless as a buyer can simply buy the shares on the market at a cheaper price. In this case, the seller retains the shares and can choose to either sell or hold the shares or sell another call with a new strike price and expiry date. This can be repeated if the option continues to remain unexercised to generate ongoing income.

If the underlying security trades above the nominated strike price, the seller may need to deliver the shares to the buyer on or before the expiry date at the strike price, depending on the type of call.

A covered call strategy may be able to be used with securities held on a margin loan, as part of the Exchange Options Plus feature.

Key features of a covered call strategy:

• Generate additional income on a portfolio with existing holdings.
• A strategy suited to a flat or gradually rising market.
• May cushion or offset losses in a falling market due to the extra income being received.

Case Study

David buys 1000 shares in Company A through his margin loan which trade at $76.50 at the time of purchase, giving a total investment value of $76,500.

David decides to implement a covered call strategy and is prepared to sell his shares at $80 selling an ‘out of the money’ covered call. He sells the call with an expiry date in 30 day’s time. In return for the commitment to sell at this price, he receives a premium of $0.70 a share, thereby generating $700 in additional income for the 1000 units held.

Possible Outcomes

If the company trades above $80 on expiry:

In this case, the option position is ‘in the money’ and the option holder will exercise the option to realise the ‘intrinsic’ value held, which is the difference between the price now and the option exercise price.

If the company trades below $80 on expiry.

In this case, the options position is ‘out of the money’ and will likely expire worthless. David can then either retain the shares, sell the shares himself or sell a new option repeating the process.

Factors to keep in mind:

If Company A trades above $80 on any day before the expiry date, the security will be an ‘in the money’ position. David may be able to continue to hold the security up to the expiry date. It is up to the buyer of the call whether the call is exercised dependent on the type of call held. The option is often automatically exercised if the share is trading above $80 at the expiry of the option.

David may not want the risk of being exercised prior to expiry, in this case he can choose to sell the call ‘European’ style instead of an ‘American’ call. A European call can only be exercised on the expiry date and not beforehand, unlike the American call which can be exercised any time at the buyer’s discretion. This may be useful for investors who want to retain the dividend themselves. Usually however this will be reflected in the premium and there will be a difference between premium amounts of both types of option. Low exercise price options (LEPOs) are not permitted to be written under the Exchange Options Plus feature.

What happens if the share remains flat or increases gradually?

Let’s assume the share closes just under $79.99 on expiry. This is potentially the most ideal scenario with a covered call because David has profited from his underlying position in Company A rising, which generates a capital gain (unrealised), as well as retaining the shares. In a flat or gradually rising market, covered calls tend to outperform a long only portfolio due to the additional income.

What happens if the Company A share increases in value dramatically?

If the share increases to $82 at the options expiry, David’s call option will most likely be exercised, which means he will need to sell the share at $80 (the strike price).

In this scenario, David has still profited from the trade, as he will keep the $3.50 per share profit from the share, which increased from $76.50 to $80. In addition, he will keep the $700 premium from the sold call, along with any other dividends or franking credits he may have been entitled to.

However, the downside is that David will not benefit from any further increase in the share price above $80. In a quickly rising market, coved calls tend to underperform a long-only portfolio, as capital gains are capped by the written calls.

What happens if the Company A share declines in value?

Let us assume that, at expiry, the shares for Company A are trading at $72.00 and are out of the money.

Given that David purchased his shares at $76.50, he will be down $4.50 per share if he did not sell the call, being a total unrealised loss of $4,500 on the 1000 shares held.

Given he sold the call and received a $700 premium, his loss would be reduced to $3,800 ($4,500 unrealised loss minus the $700 credit from the sold call premium). While this is still a negative outcome, David is still in a better position than if he had not sold the call at all. In a falling market, covered calls tend to outperform a long-only portfolio, although the unrealised capital loss still needs to be taken into consideration.

While this is still a loss, selling a call has put him in a better position than if he had just purchased the share. However, it should also be considered that by selling the call option, David needs to hold the shares until the call option expiry so it remains covered, which prevents him from selling the shares during that time period.

Risks in using options with gearing.

The risk of a covered call strategy is the opportunity cost of having to deliver shares if an option is exercised at a strike below the current market price.
However, there are other risks which should also be considered, including the cost of having to buy back an option should there be the need to liquidate the position (for example, due to a margin call).

There is also the risk that the strategy may not perform as expected, or the premium earned through selling a call option may not cover interest and operational costs of the margin loan.

In all examples, David should also consider the interest payable after buying the shares and the impact on his total return inclusive of any options positions written.

It is strongly recommended a financial adviser licensed in derivatives is consulted for advice on the strategy and taxation advice before embarking on an any options strategy.

How to get started

With Exchange Options Plus, you too can discover Covered Calls.

Speak with your financial adviser to discuss whether options trading is right for you. To enable options trading on a Leveraged Margin Loan using Exchange Option Plus, contact us today on 1300 307 807 or customerservice@leveraged.com.au

If you are financial adviser and want to learn more about recommending gearing or Exchange Options Plus to your clients, contact one of our Business Development Managers.