Stephen Karpin, CommSec

Question:

What is a popular options strategy for traders?

Response:

Covered Calls — Generating additional income from your stocks

This options strategy provides a way to increase income from stocks you already hold, using what is known as the ‘Covered Call’ strategy. This strategy supplements the return on a share investment, which is typically capital growth, plus income from dividends.

A call option is the right but not the obligation to buy a particular share for a predetermined price, on or before a particular date.

Buyers of a call option buy the right to buy shares (‘call’ the shares away from the seller).

Sellers of a call option are obliged to sell their shares should the buyer wish to purchase them at the agreed price.

Options are traded in contracts, with one contract generally covering 1000 shares.

The covered call strategy involves selling (writing) a call option over the stock that is already held in your portfolio. In return for the obligation to possibly sell their stock at some point in the future, the seller receives a payment or ‘premium’ upfront. The size of this premium will depend on numerous factors, including the agreed sale price (strike price), the time to expiry of the option, and the volatility of the particular stock involved.

Example: BHP is currently trading at $42 Dollars and your view is that the market is likely to move sideways over the next few months. You decide that you are willing to sell the stock at $43 but no less. You sell a covered call at $43, generating $0.90 per unit ($900 total for contract based on 1000 shares) for the next month.

Advantages

The benefits of this strategy are:

* You generate additional income from the Call premium.

* You continue to receive all ordinary dividends over the life of the strategy, subject to the risk of early exercise.

* You retain access to all corporate actions (such as share purchase plans) that may occur while the stock is held in the Covered Call.

* You receive limited protection against a falling price — equal to the premium you receive.

Disadvantages

The possible disadvantages of this strategy are:

* Your capital growth on the underlying share is limited to the strike price.

* You are still exposed to the full risk of holding the stock.

* You are also exposed to the risk of having your stock assigned (sold) under the Call Option.

Risk vs Reward

Best Case = Your stock stays around the same price or rises to just below the strike price of the option you have sold. You retain both the stock and the call premium.

Breakeven = Your stock drops by the value of the option you have sold. You retain the stock and have lowered your cost price by the value of your written call.

Worst Case = Your stock drops by more than the value of the option. You have an unrealised loss on the stock partially offset by the premium received for the written call. OR The stock rises well above your call’s strike price and you are forced to sell the stock for less than its market value. You have missed out on potential profits.

The covered call would be one of the most popular strategies as it is relatively easy to understand and implement. Whilst there is potential to cap profits on the stock, covered calls have the potential to provide monthly income, in addition to normal dividends, with no more downside risk than simply holding the shares.

Important Information

The views expressed in this article are those of Stephen Karpin, a representative of Commonwealth Securities Limited (CommSec) ABN 60 067 254 399 AFSL 238814.  Commonwealth Securities Limited (CommSec) ABN 60 067 254 399 AFSL 238814 is a wholly owned but non-guaranteed subsidiary of the Commonwealth Bank of Australia ABN 48 123 123 124 and a Participant of the ASX Group.

This article was produced by CommSec. The information in this article is general in nature and does not take into account any investor's particular objectives, financial situation or needs. In considering its appropriateness, investors should read the relevant product disclosure statement and consult a financial adviser before making an investment decision. Except to the extent that any liability under any law cannot be excluded, no liability for any loss or damage which may be suffered by any person, directly or indirectly, through relying upon any information or statement in this document is accepted by the Commonwealth Bank or CommSec or any of their directors, employees or agents, whether that loss or damage is caused by any fault or negligence on their part or otherwise. Commonwealth Bank and its subsidiaries do not guarantee the obligations or performance of CommSec or the products or services offered.

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