Saturday, June 16, 2018

Making money by selling call options

An option is a right to buy or sell shares of a company (underlying shares) for a fixed price (strike price) over the term of the option.  Say you would be willing to sell your house for $100,000.  Rather than putting the house up for sale right now, you give someone the right to buy your house for $100,000 anytime during the coming 6 months. If today is Jan 1 then the right to buy would expire 6 months from now on May 31. The call option or the right to buy the house expires on May 31. $100,000 is the strike price. The house is the underlying (asset).

You can do the same with shares. Say I own a share of TD Bank which currently trades at $76.  I sell you the right to buy my TD anywhere over the next 6 months for a strike price of $75.   Hé wait a minute! You sell me the right to buy a TD share over the next six month for $75 while it is already trading at $76?  Yes, we call that a call option that is IN the money. It is already worth $1 ($76-$75). That one dollar is called the option’s intrinsic value. If you own the option and six months from now TD is trading at $80 then the option’s intrinsic value has increased by that date to $5 ($80-75).

What? You sell me an option, a call option that gives me the right to buy your TD share for $75 when it is trading at $80?  Yes, how much do you want to pay me for that call option?  Eh… wait a minute, what if TD doesn’t go up to $80 but instead it falls to $70?  In that case the call option would be worth nothing right?  After all nobody in their right mind would buy a TD share from you for $75 if it only trades for $70!  If you, the call option buyer, pays me $2 (the option premium) to sell you a TD share that is worth today $76 for $75 anytime over the next six months then $1 goes towards the intrinsic value and the other $1 would be for what?  It would be for the value of the term or the time before the option expires!
After all, I own (in case of a ‘covered call’) 1 TD share worth $76. You pay me $1 intrinsic value plus $1 for the time value totalling $2 and if TD trades at $80 at the expiry of the option or when it is exercised prior to expiry you made $5 profit on a $2 dollar investment or 250%.  Now, if I kept the TD share I made $4 profit on my TD share for which I paid $76 or just over 5% plus two quarterly dividend payments. While, if I sold you a call option for $2 then I made $75-76 plus $2 plus the dividend, i.e. I made $1 more profit (plus dividends) than if I had sold it for $76! 

But if TD had fallen over those 6 months to say $74, I would not have gotten $76 and the option expired worthless. IN that case I would have owned a $74 share (which may appreciate over time) plus $2 premium plus dividends. I reduced the risk of a loss. By selling a call option I reduced my downside.

Let’s step back. I buy TD for $70 and a while later, it trades for $76.  If I sell it , my profit is $6 plus dividends. Rather than selling, I try to squeeze a bit more cash out of the deal by selling a call option. I am willing to sell TD for $75 plus I will collect the call option premium of $2 dollars plus 6 months of dividends. Yes, I limit my upside, but I was already happy with the $6 appreciation and now I get $1 more, i.e. $7 of profit (plus dividends). That is an extra 1/75 x 100% over 6 months or an extra 5.3% annualized. And if the share price falls, I just hold on to the stock a bit longer and have an extra $2 in cash. I increased my profit while reducing the risk of holding on longer. And, if the call option expires worthless, I can ‘write’ a new option. If I receive another $2 dollar premium for the next 6 months, even if TD stock doesn’t change, I made nearly a 9.9% return that year.  Writing covered call options is a very conservative way of earning cash flow and providing downside protection.
The buyer of my option has an extremely leveraged play where in six months he/she can make a 500% profit annualized (2 x 6 months) or… lose the entire $2 investment. High risk and high reward. But what if TD had fallen say from $76 to $70? The buyer of 1 TD share would have lost $6 on his purchase while by buying the call option he lost only the $2 premium! So maybe buying the call option was not as risky after all. 

Options are traded as ‘contracts’, a bundle of 100 options with 100 shares as underlying. You can sell call options as an income generating strategy. Say you want to buy 100 TD shares.  It pays say $3.50 dividends per year per share. Your investment is $76 x 100 = $7600 and you will earn $350 in dividends. Now write a call option contract for $2 for 6 months and with a strike price of $75. You collect $200 in premium and if the options expire worthless because TD shares fell below $75 then you made $350 plus $200. If you write a 2nd contract for the rest of the year (another 6 months) and the shares still ended up at $75 then you earned another $200. Now your cash flow is not $350 but rather $750.
Say, the shares were $77 after 6 months. You could have bought the call option back just before expiry for the intrinsic value of $2  (the time value declined to $0) and kept the profits on the shares now $77 (i.e. you broke even on the option but made a dollar on appreciation of the shares plus dividends). Then you sell for the next 6 months another call for $2 of $200 for the contract. Now you have $550 in cash flow plus $7700 in TD shares ($100 appreciation) for a total ‘profit of $650. 

If you’d bought an extra 100 TD shares when the shares were at $76 and had the call option exercised instead of sold, you would have made $350 plus $200 premium plus $200 appreciation- again $750 cash flow! But you had at least during part of the period nearly $1530 rather than $7600 in cash tied up in the TD deal. Either way, that year your income or cash flow would have been nearly double the regular dividends and… you’d have less downside risk compared to owning the TD shares outright.
Never sell calls on shares that you don’t own (selling a 'naked' call). That would be the same as ‘Shorting’ a stock and your losses could be infinite because you would be forced to buy the TD shares at expiry for possibly a much higher price so that you can sell them for the strike price of $75. Say TD went up to $100 you’d lose $25 per share.  Say TD traded at $200, then you’d lose $125 per share. What if the TD share price shot up to $1000?  Now you can see that selling a ‘naked call’ is a recipe for disaster and far from conservative prudent investing.  In the next post I will show you the story in a spreadsheet.

As, by now you may realize, when trading in covered calls and naked puts, a lot of 'what-if' has to be considered. A good workout for your grey power!

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