Sunday, June 17, 2018

Selling covered calls reduces overall portfolio risk and increases your cash flow

The previous post was for the more numerical challenged but writing it made my head go spin around. So lets look at the story in a spreadsheet. (I hope I did all the math consistent).
In the previous post, I use 1 single option which deals with 1 underlying share. In real life, options are traded in bundles: A bundle of 100 options is called a ‘contract’. Options are traded in contracts but the price (premium) is quoted for a single option. Say, the option premium is quoted at $2 then you buy a contract (100 options) for $200 (plus brokerage commissions). 

Brokerage commissions at a discount brokerage are typically around $10 for the first contract and if you buy or sell more then you pay around $1.25 for every additional contact.  Thus a commission for 3 contracts (300 options) is $10 plus 2 x $1.25 = $12.50.  If you trade options through full service brokerages you may end up paying 100s of dollars in commission which makes option trading often a very expensive game. Only trade options through discount brokerages.

Thus the spreadsheet is for 1 contract or 100 options with 100 shares as the underlying asset. When you sell call options you are taking on the obligation to sell the underlying shares for a fixed price (strike price) . In our example with TD Bank shares, when selling 1 call contract expiring over 6 months at a strike price of $75 then you make the commitment to the buyer to sell him or her 100 TD shares for $75 regardless what it trades for in the market during the next six months. 

Now, what would happen if you did not own those shares and they were trading in the market for say $80 per share?  Yes, you would be obligated to buy 100 TD shares for $80 each or for $8000 and sell them to your option buyer for $75 per share or a total of $7500. That would be an instant loss of $500. If the shares traded at $100 dollars instead, your instant loss would be $2500 dollars.  That could become very painful and that is the reason why you should only sell call options on shares you already own.  That turns the high risk ‘naked’ option trade into a conservative ‘covered’ call trade. 

With put options you take on the risk to buy 100 shares per contract for the strike price.  Now, since you don’t own these shares already, this is a ‘naked’ deal. When you write or sell a 'put option' took on the obligation of 1 put CONTRACT with a strike price of say $75. When the contract gets exercised, you’d better have the cash! That means you must have access to 100x $75 or $7500. So, although selling put options seems like making cash out of thin air, or if you were a central banker, it may feel like printing money… but you must have the means to buy the shares you committed to!  

Writing put options is ideal if you have a lot of cash, and you want to make a bit more than the interest your brokerage pays.  Only sell puts on shares of companies you’d love to own anyway and the strike price should be the price at which you are willing to buy those shares anyway! 

So here is the covered call spreadsheet with 4 scenarios. Each scenario compares holding 100 TD shares outright versus in combination with sold call options.  Note that each scenario has 2 six months periods and that the dividend yield is 4.6%

Scenario 1 shows a large upward price movement. The 2dn scenario shows break even prices.  Click on tables to magnify

In the tables below we show what happens when there is a small loss and when there is a large loss.
Scenario 3 shows a small price loss and the last scenario shows a large loss. Click on the tables to magnify.

When comparing the 4 scenarios (which covers most outcomes) then you may notice that when selling a call option to restrict your upside in terms of appreciation to the strike price. So with a large upwards jump in prices you make a maximum total profit of 9.9%  If the share price jumped even higher to say: $85 dollars, with outright share ownership you'd make 16.4% but the return on the call option scenario would be capped at 9.9%

So in return for capping the upside, when the share price doesn't move over the 12 months of the spreadsheet, you would make only 4.6% (the dividends) on outright ownership while with the call options do remain at 9.9% return!  If like in scenario 3, the share price drops to $75 then in the outright ownership case your return is reduced to 3.3% while with the options you'd still made 8.5% and if you drop to a share price of $70, a nearly 10% drop in price, then you would lose 3.3% but the options would buffer the loss and you'd turn a small profit of 2.0%.

Cool he? Now, if the stock price is temporarily down after six months, you can still hang on for the stock to recover. Just look at the price movements of TD and you can see that over the long term the price tends to go up. In the meantime you can keep on collecting option premiums thus nearly doubling your cash flow from the dividends. From a long term perspective, writing or selling covered call options increases your cash flow and it reduces your volatility. Something worth to try?


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