floor-traders-exchange

Risk of Losing All Shares:

Each contract exercised represents 100 units of stock. Shareholders who sell options on all their underlying stock risk losing their entire holdings. So, investors and advisors should consider what percentage of their underlying stock they want to sell options on. Some investors sell options for shares they would purchase only if the option is called, but such naked call options don’t qualify as a covered-call strategy.

Implementing a covered-call strategy is a balancing act.A strike price can be set at any dollar value, but premiums will be highest when it’s close to the market price, or “close to the money.” Options can be written for any strike price and for any time frame. In a volatile market, the underlying stockholder runs the risk of having the stock called away, forcing the sale to the option holder at a time when its price may continue to increase.

Dividend-Paying Shares Have Lower Premiums:

Writing covered calls on a dividend-paying stock may look like a simple way to add value to a portfolio, but it isn’t always, says Charbonneau. Dividend-paying stocks command a lower option premium because the “dividend yield of the stock reduces the stock’s volatility.” This makes it less attractive to speculators who typically employ covered-call strategies and buy call options.

Taxation:

Any income derived from a covered-call strategy is typically considered a capital gain, although there are some cases when CRA views it as regular income. Such cases include when someone trades options for a living or a client owns securities for a short period (for a full explanation, go to advisor.ca/coveredcall). Losses are considered capital losses.

Client implications

Clients who have a mid-to-long term investment strategy may benefit from a covered-call strategy. However, Charbonneau points out a client needs to “truly understand the call and put options payoffs and risks. The investor needs to have time to dedicate to watching the capital markets.”

Risk-averse investors are, by definition, poorly suited to covered calls. Those with minimal knowledge about the inner workings of capital markets, and who can’t afford to lose the stock if the call is exercised should also stay away.

“Any client who actively trades stock or wishes to employ a short-term investment strategy will not benefit from covered calls,” Kostic adds.

Charbonneau says “a sideways trending market with moderate volatility” creates good conditions for covered calls. It puts investors in a position to earn consistent premium income while continuing to hold their underlying stock positions.

Kostic adds higher volatility can create higher premium income as speculators look for stock deals. That higher volatility, though, increases the risk the stock will be called away.

“Used correctly, it can be an effective subsidization strategy,” says Charbonneau. “It provides a means for investors to increase their portfolio value while reaping the benefits of owning the stock; and it offers downside protection if the value of the underlying stock drops.”

Variations to covered-call contracts

When one options contract expires, shareholders can issue a new covered-call option with a new strike price and a new expiration. They can also issue different covered calls for different strike prices and different time periods on different numbers of shares to further offset volatility, as long as the shareholder owns enough underlying shares to fulfill an option call.

If the price of the underlying stock drops, the issuer of the call option can buy it back at a price dependent on the option premium, and then issue a new call option for a lower strike price.

Philip Marion, associate investment advisor with Macquarie Private Wealth, adds investors who employ covered-call strategies often further mitigate risk by purchasing put options on the underlying stock, which gives the investor the right to sell stock at a set price within a certain time frame. This is useful if the stock price increases suddenly: a put lets the investor sell the stock at
that higher price. Should the stock price then fall, he can protect his investment.

Justin Charbonneau, vice president and portfolio manager at Matco Financial Inc., says, “The key when implementing a covered call option strategy is to maximize option premium yield while minimizing the risk of being called away on the underlying stock position. If the investor sells shorter-term call options on a regular basis, he or she can benefit from continual premium infusions as long as the options are not called, which would require a sale of the underlying stock.”

Originally published in Advisor's Edge Report

Add a comment

Have your say on this topic! Comments are moderated and may be edited or removed by
site admin as per our Comment Policy. Thanks!