A beginner’s guide to writing covered calls

Michael Gable

The market is range-bound, and many shares just don't seem to be going anywhere. One strategy that we are now getting many questions on is that of covered call writing. This strategy is not for everyone, but many investors are finding it helpful in the current environment. Here is a basic guide to how it works.

  • A call option gives the holder the right to buy a security at a certain price (the strike price) by a certain date (the expiry date).
  • Writing (selling) options is a strategy used to protect portfolio’s and also pick up additional income.
  • It is ideal for long term investors who want to protect their shares without selling them.
  • Only 15% of options are exercised and the rest are either closed early or expire worthless.
  • An option is a decaying asset. That is, with all else being equal, it will lose value every day that passes.
  • Writing options therefore has a higher probability of becoming profitable.
  • Covered call writing is an effective way to protect your existing portfolio.

WHO IS IT SUITABLE FOR?

  • Investors seeking extra income
  • Self Managed Super Funds
  • Stocks bought on Margin Loans
  • Wealth Accumulators
  • High Net Worth Individuals

TYPES OF CALL OPTIONS

  • In the money. This is where the stock price is greater than the strike price. For example, if WES is at $43.50, and the strike price is at $42.50, then the option is $1 in the money.
  • At the money. This is where the stock price is the same as the strike price. For example, if WES is at $43.50, and the strike price is at $43.50, then the option is at the money.
  • Out of the money. This is where the stock price is less than the strike price. For example, if WES is at $43.50, and the strike price is at $44.50, then the option is $1 out of the money.

HOW DOES IT WORK?

CASE STUDY

  • If WES is trading at $43.50, a call option expiring in one month with a strike price of $43.50 could be sold for $1.20.
  • Therefore with one month to expiry, a client with 1000 WES shares is able to pick up $1200 in income (or 2.8% of their holding).
  • If WES closes below $43.50 at expiry, you would keep the premium ($1200).
  • The downside to the strategy is that if the share price goes up, then gains are therefore capped at $1.20 for the month.

COMPONENTS OF AN OPTION

  • Option value = time value + intrinsic value.
  • Intrinsic value is the difference between the share price and the strike price (when the option is in the money).
  • Time value is greatest for an at the money option.
  • An in the money option is made up of intrinsic and time value. For example, if WES is $43.50 and the option strike is $42.50, the option will be worth $1.80 ($0.80 time + $1 intrinsic)
  • An at the money option has no intrinsic value and is therefore just time value. Using the same example as above, the option will be worth $1.20.
  • An out of the money option also has no intrinsic value, and is made up of a smaller amount of time value. The $44.50 option on WES will be worth $0.70.

DELTA – HOW AN OPTION CHANGES VALUE

  • Delta refers to the movement in the option price, relative to a movement in the share price.
  • When the share price changes, the corresponding value of the option will also change but only as a percentage of that particular change.
  • At the money is 50%.
  • In the money is 50% – 100%.
  • Out of the money is 0% – 50%.
  • Delta can also be thought of as the probability of finishing in the money. So as we get closer to expiry, the delta will change.

TIME DECAY

WHICH OPTION TO WRITE?

  • In the money. If the stock price is likely to pull back a considerable amount, then an in the money will yield higher results.
  • At the money. If the stock price is more likely to consolidate around current levels over time, then you need maximum time decay.
  • Out of the money. If the stock price has a chance of edging higher between now and expiry, and you have sufficient share to make it worthwhile.

GETTING STARTED

HOW TO BE SUCCESSFUL

  • Monitor your positions every day. As the market can move quickly, you may be presented with an opportunity to lock in the vast majority of your profits. By locking in these profits, you are also removing the risk of losing all of your profits in the event that the share price rallies. Profits are capped so you need to know when it is unrealistic to be holding out for the final cent or two. Unfortunately most people who do not trade full time cannot act quickly enough to maximise their returns.
  • Make use of Technical Analysis. You may be a long term investor, but the market can continue to be irrational in the short term. The more you can identify short term weakness in the market, the more you can identify an opportunity to write a covered call. Conversely, if you can identify when the market is going to rally, then you have a better chance of knowing when to be locking in profits.
  • Understand risk/reward. An in-the-money option can generate greater income but requires a greater movement in the share price in order to expire worthless. An out-of-the money option will generate less income but doesn’t require the stock to move at all in order to expire worthless. An at-the-money option will generate the most time value. Each type of option will be more/less appropriate depending on what your view is for the market.

More information can be found by downloading the Understanding Options Trading guide on the ASX website. The ASX website also contains further information on options in general. We highly recommend that investors do further research of their own.

Any advice is general only. Fairmont Equities uniquely combines both fundamental and technical analysis. Visit our website and get our free newsletter. Join the thousands of investors that receive our analysis and educational articles every week.

*The chart used in this article was sourced from quant.stackexchange.com


Michael Gable

Michael Gable is managing director of Fairmont Equities. We are a small boutique advisory that uniquely combines both fundamental and technical analysis. As a result, our analysis is featured regularly in the finance media such as the Australian...

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