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How covered call options can be a profitable tool Add to ...

In the pursuit of income, many investors are using a technique that lets them collect cash up front in return for giving up potential gains on their stocks.

The strategy is known as writing covered calls. It consists of selling somebody else the option to buy a stock you already own, at a set price, for a certain period.

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In the worst case, the stock soars far above the set price and the buyer of the option "calls," or buys, your stock from you.

On the other hand, many call options never get used. In that case, you get to keep your stock - while also collecting a nice piece of cash for "writing," or selling, the option that wasn't exercised.

Used effectively, the writing of covered calls can allow an investor to reap a steady stream of payments from a portfolio and still benefit from some capital gains. It can be especially appropriate at a time like the present, when the market is coming off big gains and may be settling into a trading range.

But covered calls aren't for casual investors.

"I've always liked covered option writing as a strategy. I think it's quite a legitimate one. But, boy, you have to know what you're doing. You have to be disciplined," says Eric Kirzner, professor of finance at the Rotman School of Management at the University of Toronto.

Caveats

On the positive side, writing covered calls doesn't expose an investor to unlimited risk the way some other options strategies do, because the investor owns the underlying stock and is therefore "covered."

The problem is that by writing covered calls, you're losing out on a stock's future gains and those gains could be many times larger than the cash you're receiving for writing the option.

"Like a lot of things, the devil is in the details. Investors are giving up some upside in the stock when they sell a call. The real question is what fee are they getting paid to give away the [upside]" says Hanif Mamdani, head of alternative investments at RBC Global Asset Management. "To me it comes down to whether you are getting systematically overpaid for giving away those outcomes."

More than 20 years of experience has taught Mr. Mamdani that it's very difficult to get that premium consistently. As a result, he doesn't employ covered calls in his own investing strategy.

Fair Price

To succeed, investors have to outwit professional options traders armed with sophisticated software tools designed to find under- and overvalued options.

Determining the fair price for covered call options can be more complicated than assessing the right price for the stock itself. That's because options have more variables, including the time to expiration and the volatility of the underlying stock.

"If you are a retail investor engaging in covered call writing, you have to know how to value a call option," Mr. Kirzner says. "Unless you're prepared to understand that, this isn't for you."

Investors also need to factor in commission costs and realize that writing covered calls on their shares fundamentally changes the asset allocation of their overall portfolio, he adds.

Online Tools

Many tools are available online and through software packages to help covered call writers, including implied volatility calculators. The website of the Montreal Exchange, which set records for options trading volume last year, is a good starting point for investors studying valuations of Canadian options.

In addition, some online brokerages offer educational, pricing, research and trading tools for writing covered calls, although most require investors to apply for an options account before they can trade.

When To Use It

Writing covered calls allows investors to boost their returns in a flat market. It is also one of the few options strategies that may be employed in a registered savings plan, says Joel Bernard, vice-president of Qtrade Investor, an online brokerage based in Vancouver. Covered calls have gradually become popular at Qtrade, and now represent about 20 per cent of the options volume.

Generally, covered call writing produces the best returns when markets are calm, reducing the chance that a stock will jump in value and be called away by the option holder. It's particularly effective with "dead money" stocks that are stuck in a tight trading range.

Conversely, writers of covered calls stand to get the best prices on their options when markets are volatile and buyers sense more opportunity for price swings.

These broad trends may sound fairly simple to assess and ride, but Mr. Mamdani warns otherwise.

"People think they can identify stocks that are dead money - that the stock is not going to do anything for the next six months or year, so why not write some calls against it?" he says. "That seems like an intuitive thing to do, and yet it is very difficult in practice. Stocks can move for all kinds of reasons."



KNOW YOUR OPTIONS



The Montreal Exchange



The sole financial derivatives exchange in Canada.



Lists options on stocks, exchange-traded funds and currencies, as well as index, interest and energy derivatives.



Website resources include a list of all Canadian traded options, a covered call calculator, an options calculator and a trading calendar.









The Options Industry Council



Provides educational material about U.S. equity options.



Sponsors include the Chicago Board Options Exchange, the Boston Options Exchange, NYSE Amex and the Options Clearing Corp.



Website offers backgrounders and webcasts covering such subjects as profit and loss graphs and the Black-Scholes model for calculating the premium of an option.



Tools include pricing calculators and market data.

Follow us on Twitter: @GlobeInvestor

 

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