Option Strategy: Writing covered calls is an excellent option strategy to use options in aonline option trading low risk way, to generate additional income on your existing portfolio of stocks by online trading. If you buy shares at the same time that you write the call then the transaction is known as a buy-write. If you write calls on shares you already hold then it is called an over-write.
The covered aspect comes from the fact that you own the underlying stock or share. If the contract is exercised then you have the underlying goods to fulfil the contract ( like the car in our first example). There is another type of call writing called naked. NEVER, EVER write naked calls – these are uncovered, not covered, and you are exposing yourself to UNLIMITED RISK. As a novice trader it is very unlikely that you would be allowed to traded uncovered anyway, but even when you have some experience of trading options, I would urge you never to write naked calls – you will lose all your trading capital and more!
Option Strategy – The Over Write
Let’s look at the over write first as our option strategy and see how it works. Now there is one difference between UK equity options and US equity options. In the UK one option contract relates to 1000 shares, but in the US one option contract relates to 100 shares of stock. Imagine you have a portfolio of stocks that you have held for some time and these are mainly UK blue chip companies. One of your stock is British Airways which you have held for some time, and you have 1500 shares bought at 200p. The market price at the moment is 365p per share. It is June and you decide to look at the current option chain for the next expiry period which is September. The option expires on the 15th September. You look at all the strike prices available and see that there are contracts at 330p, 360p, and 390p. You check the premium of the contract at 390p and see that the premium is currently 16p. You decide to sell ONE contract for which you receive a premium of 1000 x 16p = £160.00 ( the premium is multiplied by the number of shares for one contract i.e. 1000).
Please note – you still have 500 shares left in your portfolio as you do not have enough to write a second contract. You have now sold 1 contract which agrees to supply 1000 BA shares at 390p on or before the 15th September ( American Style Contract ) to the owner of the contract if exercised in the period. In return for this you have been paid a premium of £160 which is yours to keep whatever the outcome of the contract. OK – let’s look at three possible outcomes of this contract as follows:
BA becomes a takeover target and the shares jump significantly in price to 520p per share.
The contract is exercised at 390p per share.
Your shares are removed from your portfolio and your account is credited with £3,900
You keep the original premium of £ 160
In agreeing to the contract at 390p per share, you have ‘lost’ out on the takeover news and have missed the opportunity of making 1300 ( 130 x 1000 ) on your share holding. This is the downside of writing a call option on your shares, that you could miss out on a rise in prices during the contract period. This is undoubtedly true, however there is no guarantee that you would sell your shares at this point, in other words it is only a ‘paper profit’ had you kept them. The £1300 lost opportunity profits are offset by the premium you have received to £1140. Now let’s look at another possible outcome as follows :
Competition in the airline industry becomes fierce as a new low cost competitor enters the market
The shares start to fall in value and by the 15th September have reached 295
Your contract expires worthless and the shares remain in your account
You keep the original premium of £160
The price has fallen during the period, and the contract expires. Whilst the price has declined by 65p, this is partly offset by the premium you have received, reducing your paper loss to 49p per share. You still retain your shares and any future dividends. Finally let’s take a look at the third possible outcome.
It is the summer and the markets in general are fairly quiet with little movement.
BA shares have stayed fairly flat and close on the 15th September at 390p
Your contract would probably expire worthless and the shares remain in your account
You have made a small paper profit here, and a real profit of £160.You have kept your shares and any future dividends. The reason you would probably keep your shares is that with dealing costs etc it would not be worthwhile for someone to exercise, although you can never be sure. I have been exercised when the strike and market price close at the same price, but I have also been left unexercised with prices very slightly above the strike. It depends how your broker closes out positions and reconciles their contracts – sometimes you may be lucky, other times not.
Now, with the second and third outcomes, you still retain your shares so what might you do? – write another call to earn some more income? You look to the next series ( probably Dec ) and write another option earning more income. With B, where the share is now trading at 295, you might look for a strike at 320 – 340, and with C, probably around 430 – 440. And so on, until on one contract you will be exercised. The most options I have written on the same block of shares is 4! Finally on the 5th contract the price went up and I was exercised.
Please remember it is possible to write a contract so that you have built in a loss. Suppose you purchased some shares for 250p which then declined in price , and you wrote a contract at 225p with a premium of 10p. If it was exercised you would be receiving 235p ( 225+10) for shares you had paid 250p. Now, on occasion I have done this deliberately where I wanted to get rid of the stock for some reason. PLEASE DON’T DO THIS BY ACCIDENT. There are lots of packages around that will give you a graphical display of the breakeven point – most of these are free and I will explain where to find them in the dedicated site I am developing at the moment.
Finally, I mentioned dividends a couple of times above. Naturally, whilst you hold the shares you receive any dividend payments from the company. You should be aware when dividend payments are due for two important reasons. Firstly you may decide not to write an option as a dividend is payable in the next few weeks and you decide to wait. Secondly If you do write a call and a dividend is due shortly, the likelihood of exercise is much higher right before a dividend payment. The perfect outcome of course is where you keep your shares, your premium, and a dividend is paid during the contract ! – it does happen and this is the ultimate goal for your option strategy.
Option Strategy – The Buy Write
The buy write covered call is a slightly different option strategy although the mechanics are identical in terms of outcome and follow on actions. The difference is in the strike price you choose and the period. Now in the above examples we chose BA, which only has quarterly options available. There are some heavily traded UK equity options which are available monthly, but most tend to be quarterly as the market is much smaller. In the US, because the market is enormous, most stocks will have monthly options and therefore I find this strategy lends itself better to the US markets.
The stocks you are looking for are those that are trending sideways. Remember the idea with all call writing is to find a stock that you can write an option on which will then expire worthless, allowing you to repeat the exercise. You do not want shares or stocks that are shooting skywards!!!! – when you are looking at your charts look for shares that are moving in channels sideways, perhaps have hit some resistance – we do not want highly volatile stocks either ( you will need to become familiar with volatility – both historic and implied ) -the whole point of the strategy is NOT to be exercised. When you become more familiar with these things you will see that volatility and premium price are intertwined. It is obvious when you think about it – if a share whizzes about all over the place it has a much higher chance of achieving the strike price and therefore will have a higher premium. This is particularly true on the US market – in the UK it is not so bad as those quoted are mainly FTSE 100. Please be careful, there are some real horrors. I would strongly suggest that you stay away from those in the pharmaceutical sector for example, as a new drug or a drug withdrawn can have dramatic effects on the stock price.
So, we are looking for stocks online with relatively low volatility, and preferably in the top 500 -1000 US companies by market capitalisation. They should be moving sideways on the charts in a channel in a neutral to slightly bullish trend ( after all you don’t want to be buying a stock that you should be shorting!! ). Having identified possible candidates you then check their option series and look for the next month and the next available strike price out of the money. Let’s take Dell computers as an example ;
DELL – Share price : June 21st Dell trading at $24.08
DELL – July Call Option Strike Price : $25.00
DELL – Call Option : $ 0.40
We would therefore buy 100 Dell stocks at 24.08 and at the same time write a call option with a strike price at 25.00. giving us a premium of $40. If the share price increases and we are exercised we have a profit of 0.92 x 100 + 0.40 x 100 = $132 for the month. If the share price does not increase but remains the same or falls, the premium may offset some of the decline in price, and we can then write another call. The ideal of course is that the price closes close to the strike price, so we keep the premium and the shares, and then write another option at $25 which would have a much higher premium as the share price would then be almost in the money which would give a much higher premium.
OK, that’s pretty much it on covered call writing which is one of my favourite option strategies. There are whole books devoted to the subject, and the above barely scratches the surface of the strategy so in order to provide more details I have developed a new site just on covered call writing which explains the principles in detail of this option strategy in much greater depth. There are many ways to use this trading tool, but you do need to understand the Greeks, and implied/historic volatility in order to understand the value of the premium that you are considering. Once you have started writing covered calls on a regular basis, you will discover numerous reasons why you might want to close or modify a position before expiry. There are a whole variety of online stock trading techniques that allow you to roll positions forward, to take advantage of situations that may arise during the course of a contract. All of these will be covered in a new site ( I will try to get it ready as soon as possible!! ). OK, having covered a low risk option strategy let’s move on to discover the basics of online forex trading.