Generate Income by Writing Covered Options Essay

Options Basics

Equity options are generally exchange traded instruments where the buyer pays a premium to the option writer. The option provides the buyer with the right to buy or sell a fixed number of shares at a set price on a set expiry date. The buyer is under no obligation to exercise the option and therefore would only do so when the price at expiry is favourable. The writer on the other hand has an obligation to settle if the option is exercised.

The Exchange will usually facilitate an options market for key stocks and indices.

A call option gives the buyer the right to buy the underlying stock. The writer is obliged to sell the stock at the strike price on exercise.

A put option gives the buyer the right to sell the underlying stock. The writer is obliged to buy the stock at the strike price on exercise.

Using options it is possible for traders to establish very large exposures at very little cost and is another method of gearing into a particular trade.

Fund managers will often use options to hedge the risk on their equity investments and in some cases to enhance portfolio income.

If you are not Covered you are Naked

A wise and not yet old man once told me that the fastest way to go broke was to write options.

Why? Because writing options leaves you open to risk. Potentially far more risk than an investment in shares. Or should I say an unleveraged investment in shares?

My wise friend was referring to naked options. A naked options position is where you have written an option and you do not own the underlying equities or cash to settle the exposure. Your exit strategy is to close out the open position either by buying back the options prior to expiry, if you are lucky by allowing the options to lapse worthless or by cash settling at expiry. Most exchanges that facilitate options trading enforce collateral requirements to protect against the risk of writers defaulting.

Simple Covered Strategies

Covered Call

A covered call is a call option written over stock that you own.

Example

You own own 1000 shares in ABC company and want to generate some additional income. The current share price is $20 and you are happy to sell at $21. You write 10 options to sell 100 ABC company shares at $21 in one month time at 0.50c per share. You receive a premium of $500 less transaction costs immediately. If you are exercised you will sell your shares at $21.00 and realise a further profit on the share sale of $1000 less transaction costs.

If the ABC share price was to fall you might think of buying the options back as the option price would also be cheaper. This would leave you holding the stock unencumbered.

Advantage:

Recieving additional income in the form of options premium

Disadvantage:

You have no protection if the ABC share price falls.

If the ABC share price rallies beyond $21 you will either need to buy the options back at a higher price than what you sold them for or if exercised you will be obliged to sell at $21 when the market rate for ABC shares is higher.

Buy Write

A Buy Write is a covered call which is written at the same time you buy the stock. The premium received effectively reduces the initial outlay.

Example

You wish to buy 1000 shares in ABC company currently priced at $20 and are happy to sell at $21 in a months time. You enter a buy-write deal where you pay $20 per share for the stock and recieve 0.50 per share for the option. Your effective cost is $19,500.00 plus transaction costs.

Advantage:

A cheaper net purchase price

Disadvantage:

The stock is held as collateral against the option position.

Your upside is limited to the strike price on the option

Cash Covered Put

An alternative to the Buy-Write is the cash covered put. This can be used as an alternative to leaving an order with your broker.

Example

You are happy to buy 1000 ABC Company Shares at $19.00 and decide to write a put option with a $19 strike at 0.45c per share. You recieve a premium of $450.00 less costs immediately. If subsequently exercised you will pay $19000 plus costs for the shares.

Advantage:

you receive the premium immediately.

Disadvantage:

The ABC Company Share price may rally and you might not be able to buy the stock for the price you wanted to pay.