One of the most powerful characteristics of the options market is the seemingly endless number of strategies available to meet various investor objectives.
We are taught from the onset of our investment careers (professional or otherwise) that the objective is to buy low and sell high however we reach a certain point in our life cycle when the focus turns from growth towards generating income.
There are many strategies available to help the investor generate cash flow beyond traditional dividends and fixed income securities such as bonds and GIC's. Two common strategies are covered calls and credit spreads. While both strategies require the investor to take on the roll of option writer, each have their own unique characteristics that should be considered before integrating them into an investment plan.
The covered call involves the purchase of shares and the subsequent sale of a call option contract with a specific expiration date. The covered call writer is paid a premium to sell their shares at a specific price known as the strike price. This obligation is only valid if the shares are trading at or above the written strike on the third Friday of the expiration month selected. If this is the case, the investor will deliver the shares at the obligated strike and benefit from the an increase in share value from the purchase price to the strike price. In addition they get to keep the premium. If the shares are below the written strike, the writer gets to keep both the premium and the shares.
For investors who have built a portfolio of dividend paying stocks this is a great way to increase cash flow and returns. The risk lies in the share ownership. The covered call writer will incur a loss as the share value drops below the purchase price less the premium collected. An important consideration is that the more premium collected over time, the more the downside risk is offset.
An investor may hold shares in Intel (NASDAQ:INTC) which trading at $24.70/share. At today's price, Intel is paying an approximate 3.7% dividend/year. The investor has the benefit of a potential appreciation in share value plus the cash flow from the dividend.
To enhance this return, a passive investor could sell a May, 27 strike call for $0.44/share for an annualized return of 4%. This also leaves just over $2.00 in share profits before the investor has to potentially deliver the shares. This results in a premium plus stock upside return of 11%. The main consideration is that the stock could stay with in the same trading range for the year and the investor has brought in almost 8% in yield. For many conservative investors this would be a welcome return.
The challenge for some is the capital required to hold sufficient enough shares for this strategy. For the income focused investor with a smaller account size, a credit spread can be used.
The credit spread involves the simultaneous sale or write of a close to the money option and purchase of a cheaper, further out of the option. The close to the money options provides the credit. To reduce the risk and capital requirement, a cheaper option is purchased. The risk to the investor is the difference between the spread and the credit received.
For example. With the shares of INTC trading at $24.70, an investor may believe that the price will still be below $26.00 by the January 2014 expiration.
A $26.00 strike call could be written and $0.32/share collected. At that point, the investor has taken on the obligation to deliver the shares at $26.00 regardless of how high they are trading. This represents and unlimited and unidentifiable risk. The broker will require sufficient margin to hold this position. However, by using some of the credit to purchase a call at the $28.00 strike for $0.06, the investor has capped the maximum risk. Regardless of how high the shares trade, the investor has an obligation to deliver them at $26.00, but now has the right to own them at $28.00. This limits the risk to $2.00/share. Because the credit is always the investors to keep, the broker will only require $2.00/share minus the credit as margin.
In this example, the investor would collect $0.32 and pay out $0.06. This results in a net credit of $0.26/share or $26.00/spread. The risk/spread would be $200.00 minus $26.00 or $197.40. This represents a return on risk of 13%.
With 56 days until expiration, you could do this 6 times over the year. Let's assume with a $10,000.00 account, you would risk $978.00 and execute 5 call credit spreads and collect $130.00 ($26.00 X 5) . By doing this 6 times over the year and, once again assuming that the spreads expired profitably each time, this would bring in $780.00 over the course of the year or 7.8% on your capital.
Looking at it from strictly a dollar perspective, the covered call writer would have to own 400 shares of INTC for a cost of $9880.00 and make 8% to generate approximately $780.00. In a non registered account, the position could be held on margin for 33.3% of the required capital tying up approximately $3300.00. Remember that the credit spread requires $978.00 to achieve approximately the same results. The other difference is that the maximum risk to each credit spread is $1.97/share while the share position is fully at risk.
With that in mind, one major consideration is the difference between the directional bias created. The covered call writer is BULLISH to neutral, while the bear call credit spread position is BEARISH to neutral. If the investor was bullish on the shares and wanted the benefits associated with a credit spread, the same results could be achieved using a bull put credit spread.
By implementing credit spreads on a shorter time frame, the investor has the opportunity to favor a directional bias identified at the time. Call credit spreads can be used when the primary trend is down while the a put credit spread can be implemented during periods that are primarily bullish. The covered call writer on the other hand will perform best with in a bullish environment.
The trade off for the spread is that no dividends are collected and the profit is limited to the premium collected. The covered call writer reaps the benefit of the dividend as well as the upside on the stock but has an unidentified and theoretically unlimited risk exposure.
Below is a general comparison for your review:
In conclusion, both strategies have their strengths and weaknesses and the income focussed investor must assess their objectives and determine which approach will most effectively meet their needs. In either scenario there are risks that must be evaluated before execution.
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