If you’re looking to mitigate the impact of volatility on client portfolios without increasing risk, a covered-call option may offer downside protection if used properly.
In its simplest form, says Goran Kostic, investment advisor with Macquarie Private Wealth in Toronto, a covered call is a “conservative strategy that can create additional monthly income in conjunction with dividend-paying stock.” There are two components to a covered call.
- An investor purchases shares in Company A for the current market price. To enter into an options transaction, a minimum number of shares must be held, usually 100.
- The investor then sells a covered-call option that gives the buyer the right to buy the stock at a predetermined price (the strike price) by a specified expiration date. The buyer of the option pays an immediate premium to the stockholder for the covered-call option, and the shareholder must hold the stock until the call option expires.
Three possible outcomes are:
- The stock doesn’t reach the strike price before the covered-call option contract expires. The holder of the option never exercises it, so the shareholder keeps the stock and the premium.
- The stock reaches the strike price before the covered call expires and the option holder exercises. The shareholder then sells the units of stock specified in the call option at the strike price, and then receives a capital gain for the strike price.
- The stock drops and the option value falls. The shareholder may buy back the option at a price dependent on the premium and then resell it at a lower strike price.
Most call options expire without being exercised, so the shareholder benefits from the premium paid on the option, as well as dividend payments or voting rights. Covered-call options favour investors who buy and hold stock. Even if the stock price declines, some loss is mitigated by the premium that was paid on the call option contract.
To enter into covered-call options, an individual investor must have an options margin account, and, depending on the strategy, there is usually a minimum requirement of $100,000 before that investor can exercise covered-call options on her own.
Benefits of Covered Calls
Provide Downside Protection:
Adding a covered-call strategy to a portfolio can help mitigate downside risk in a volatile market, says Justin Charbonneau, CFA, DMS, FCSI, vice president and portfolio manager at Matco Financial Inc. in Calgary.
The premiums can mitigate any losses if the value of the stock drops or remains stagnant. Kostic says many covered-call options are never exercised, because stock prices don’t always rise as anticipated.
Usually, volatility brings out options buyers, since there’s more certainty of a price increase. During such times, buying and holding stocks can be more speculative than holding an option.
If the supply of options exceeds demand, it will be reflected in the price of the option until the market balances. “The premium is not attractive to buyers in that situation,” says Kostic.
Charbonneau adds the VIX (Volatility Index) is a good indicator of options pricing, but not necessarily the volume on the options market. The higher the VIX, the more expensive the put option (i.e. buying insurance) and the more skittish investors are likely to be. The lower the VIX, the more expensive the call option (i.e. betting on stocks will rise).