Covered Call Writing Using the Over Write Strategy
Writing covered calls is an excellent way to use options in a low risk way, to generate additional income on your existing portfolio of shares. If you buy shares at the same time that you write the calls 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 – you are exposing yourself to UNLIMITED RISK.
The first technique is called over writing, so let’s take a look see how it works. Before we start 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 shares that you have held for some time and these are mainly UK ‘blue chip’ companies. One of your shares 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. (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 obligates you to supply 1000 BA shares at 390p on or before the 15th September (Amercian 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 – lets look at the possible outcomes of this contract as follows:
Outcome A – the company becomes a takeover target and shares jump to 520p
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.
Outcome B – the share price falls to 295p as competition increases in the industry
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.
Outcome C – the market is quiet and the share price closes at 390p
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 B and C, 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.
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.
