Covered Call Options Strategy

One strategy which is regularly employed by Sentinel is the 'Covered Call Options' strategy (sometimes also known as the 'Buy-Write' strategy).

This strategy is utilised for many reasons including:

  • generating regular, additional income from otherwise passive shares
  • combines easily with commonly held blue chip shares
  • creates greater share activity (called 'active management')
  • relatively simple to use and understand
  • effective in many markets conditions
  • lower risk in the options spectrum
  • provides downside insulation

Above all, the key advantage of the Covered Call Options strategy is that it allows investors to earn additional income from their existing blue chip shares.

Many blue chip shares are only held passively - that is, people tend to invest in them for the long term and simply collect occasional dividends but do very little else. This may be suitable for some investors but for those who are looking to be more active and make their shares work to their maximum potential, the Covered Call Options strategy may be worth considering.

In its basic form, this strategy works by giving up potential upside of a share, in return for a fee.

A commonly used analogy for the Covered Call Options strategy is that it is like 'renting out' your idle blue chip shares in much the same way as you would rent out an empty property.

While these explanations may sound confusing on first reading, a hypothetical example (presented below) will help illustrate how the strategy works.

Before going into technical detail it is important to note that, as with all Options strategies, investors need to fully understand what they are doing and have proper support and guidance – this is where Sentinel can help you.

Below is a simple hypothetical example of a Covered Call strategy.

The Situation & The Opportunity

You own 1000 shares of Westpac (WBC) and you do not expect the price to rise too strongly in the short term. You are earning dividends twice a year but would like to be more active and earn more income from your shares if you can.

So you contact Sentinel Stockbroking and we assist you to set up a Covered Call strategy.

Covered Call Creation

You already own 1000 WBC shares which you purchased for $20.00. To create the Covered Call strategy, we would assist you to:

SELL 1 August $21.50 CALL Option.

You would receive $0.50 per share for selling the option (so $500 in total for your 1000 shares). This amount of money (known as “premium”) is the income you earn for giving up some of the potential upside in your shares for a short period of time.

Covered Call Seller Results

By creating the strategy, you have now locked in the following:

  • in exchange for income/money – in this case $500,
  • you give someone else the right to buy your 1000 WBC shares
  • at a set price (the "strike price") – in this case $21.50
  • by a certain date (the "expiration date" - in this case August

So in simple terms, you have given up the upside in your shares above $21.50 for one month, in return for $500.

The important distinction to note is that the person who paid you the $500 for the right to buy your shares is unlikely to exercise this right unless your shares rise above the set buy price ($21.50 strike price). This means that unless WBC rises above $21.50 before August, you will not have to sell your shares and you keep the $500 premium. It is the repetition of selling of this right (by selling Call Options) several times throughout the year which can generate significant extra income.

Payoff & Breakeven Analysis

As a result of entering into this strategy, you now have the following payoff and breakeven positions:

Own 1,000 shares WBC stock @ $20.00
Sell 1 Aug $21.50 call @ $0.50
Position investment (break-even) $19.50

  • Breakeven on the 1000 WBC shares now is lowered from $20.00 to $19.50
  • Received $500 premium (income) for selling the Call Option
  • Limited downside protection
  • Maximum gain = premium plus gain on stock ($0.50 + $21.50 = $22.00).
  • There is no further profit participation in WBC itself above $21.50

The diagram below shows your payoff position:

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Possible Outcomes (At Expiry)

  • If WBC is above $21.50, your Call option is ‘assigned’ and you must sell your WBC shares at $21.50 (however you keep you call premium of $500)
  • If WBC is unchanged, your Call option ‘expires’ worthless (so you keep both the WBC shares and Call Option income of $500)
  • If WBC price falls, you keep both the WBC shares and the Call Option income. This provides limited downside protection (losses will occur below break-even point of $19.50)

Note that the Called away return (ie if WBC is above $21.50 at expiry) is $2.00 or 10% in 70 days.

It is important to mention that the Covered Call strategy simply modifies the outcome that you would otherwise have had if you held the WBC shares by themselves (ie without the additional use of options). The table below compares the respective payoffs:

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Challenges Of Covered Call Options

The main challenge from this strategy is that you may have to sell your stock at the agreed strike price ($21.50). If the price of WBC rose above $21.50 before the end of August, it is likely that you will have to sell the stock at $21.50.

However it is important to note that you would still be making a profit as you bought the stock at $20.00 originally and sold it for $21.50, plus the $500 received in options income. So in this situation, the worst you can do is sell your stock at a profit.

It should also be noted that as this strategy involves owning shares, you still have the downside risk that the underlying stock could fall (just the same as you would if you held the share without any Options)

Benefits Of Covered Call Options

The advantages of this strategy are obvious and when used skillfully, it can significantly boost investment returns and activity:

  • Income from selling Call Option
  • Partial hedge (downside protection)
  • Actively managing your idle stocks to improve returns

Learning More or Getting Started

As noted previously, this strategy (like all options strategies) involves a higher degree of sophistication and you should not transact without first fully understanding the risks and benefits and having access to expert assistance.

For more information please contact our office to speak to one of our specialist Options Advisers, or to book to attend one of our free options educational Seminars.