Or, perhaps, you have a share that has a relatively low yield which you would like to try to add to. Maybe there is a share that has had a good rally but now you feel this might be coming to an end. These and many other reasons might have you reaching for the phone to ring your broker to sell. But wait! Check to see if there are options available first.
Writing options
Writing options against existing holdings in your portfolio can augment performance by adding to the income ordinarily received from just dividends alone. With income set to continue being the target for many investors in these low interest rate times, covered option writing, quite rightly, has earned its place in any sophisticated investor’s trading arsenal.
Investors who use this technique can often outperform those who prefer to use a more vanilla system as, over a period of say 12 to 18 months of continuous writing, in a trendless to slightly upward/downward trending market, the extra income received can help reduce costs of the original share holdings.
Writing call options puts a cap on profits and thus, if a share that has been written against moves higher, the options may well be assigned, selling the shares more cheaply than if you had not written options.
There is always a trade-off between risk and reward, with higher risk investors expecting a higher reward.
The process of writing options, if done in a covered, pragmatic fashion, can reduce risk because the premium received is used as an imperfect hedge, using the extra income as a cushion against weakness in the underlying.
From the example on the right, one can hopefully see where the strength of option writing lies. Despite the shares falling slightly, the option writing client has outperformed his plain vanilla share investor cousin by 2.5%.
Strike price
If the shares had risen instead of falling and, say, resided at 219p by June expiry, the option writer would still be outperforming because the option would have expired worthless, meaning the shares would have effectively been bought for 195p (200p minus the 5p in option premium received). It is only when the underlying shares rally through the written option strike price that under-performance is possible and even then, this under-performance only starts to really kick in at the breakeven level of 225p.
There are strategies that one can adopt if this were to happen, with a favourite of mine being writing put options at or close to the strike price of the original call option assigned. This then gives limited profit potential/exposure to the shares and, if they then subsequently fell, the investor would buy the shares back, potentially at a level less than what he originally sold at.
This article hasn’t addressed the real risk of losing dividends when writing call options, a factor that needs to be seriously thought about.
