There is a Zinifex example below, and also the ASX explanation of the strategy below.
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Julius Garofali from Shaw Stockbroking looks at several buy write strategies with Zinifex.
Catch the stock going ex dividend $0.70 on the 16 October 2006!
As you can see ZFX share price has corrected traded between $11 and $12 during September.
The time for my buy and write has come. I have found that there is potential for me to achieve a maximum of around 10.8% return in 2 months time. Here's how:
ZFX = currently $12.18 ( 2 October 2006 ) |
|
1.) Buy 5,000 shares @ $12.18 |
$60,900 |
2.) Sell 5 ZFX October 2006 $12.50 CALL options @ $0.30 |
$1,500 |
3.) The stock goes Ex. Dividend on the 16-Oct-2006 for $0.70 |
$3,500 |
4.) My capital gain potential is $0.32 |
|
TOTAL: $1.32 or $6,600 |
$6,600 |
BREAK EVEN USING THESE NUMBERS IS $11.18
($11.18 Less the dividend of $0.70 and the option premium of $0.30) |
|
The following are some likely scenarios:
1. Stock goes up and you get exercised before the dividend
This would usually happen in the month your option expires and the same month the dividend will occur. So October is the likely time this may happen.
Some other times it happens is when the stock rallies prior to ex. date and the buyer of your call exercises you because he definitely wants that dividend.
i) You lose your shares at $12.50 = profit of $0.32 (12.50 - 12.18) |
UPSIDE |
ii) You are Entitled to the whole option premium = $0.30 |
UPSIDE |
iii) You will not get the $0.70 dividend |
DOWNSIDE |
TOTAL RETURN: $1.00 / $5,100 or 8.2% |
|
2. Stock goes up and you get exercised after the dividend
i) You lose your shares at $12.50 = profit of $0.32 (12.00 - 10.95) |
UPSIDE |
ii) You are Entitled to the whole option premium = $0.30 |
UPSIDE |
iii) You got to keep the $0.70 dividend |
UPSIDE |
TOTAL RETURN: $1.32 / $6,600 or 10.8% |
|
Bear in mind, on the above scenarios, you may be exercised when the share price is at anytime, however this is most likely to occur on the day before the stock goes ex dividend.
This is because the CALL option buyer may want the dividend and the franking credits which adds up to around $1.00. So $0.70 for the div. and $0.30 worth of franking credits (the franking credit is fully franked).
3. Stock stays flat @ $12.18 -till expiry. You don't get exercised
i) You keep your shares, your breaking even on your shares. |
|
ii) You are entitled to the whole option premium = $0.30
(Remember the option premium is worth Nil at expiry) |
UPSIDE |
iii) You got to keep the $0.70 dividend |
UPSIDE |
TOTAL RETURN: $1.00 / $5,000 or 8.2% |
|
4. Stock drops to $11.18 -by expiry. You don't get exercised
i) You keep your shares. The paper loss however is $1.00 per share. |
DOWNSIDE |
ii) You are entitled to the whole option premium = $0.30
(Remember the option premium is worth Nil at expiry). |
UPSIDE |
iii) You got to keep the $0.70 dividend. |
UPSIDE |
TOTAL RETURN: $0.00 / BREAKING EVEN |
|
My thoughts on the above is that even if the stock drops, I am holding a long term portfolio stock regardless so in my eyes I see myself making $1.00 per share or 8.2% so far.
5. Stock drops to $10.50 - till expiry. You don't get exercised
i) You keep your shares, however the paper loss is $1.68 |
DOWNSIDE |
ii) You are Entitled to the whole option premium = $0.30
(Remember the option premium is worth Nil at expiry) |
UPSIDE |
iii) You got to keep the $0.70 dividend |
UPSIDE |
TOTAL LOSS: $0.68 or 5.6% |
|
Again, It doesn't worry me if the shares are weaker, I am a long term holder, so again I am making
$1.00 per share or 8.2% so far.
On points 3 to 5 after the option has expired. you then have the opportunity to sell another option series again and again, therefore bringing in a recurring income stream.
Covered call writing is easy once you know how, however as with all things new it can be a little daunting at first. With a list of action items to check off against you'll wonder why you haven't been writing covered calls before. With that in mind here is our checklist.
1. Select a stock.
This is by far and away the most difficult part of the process. The reason we say this is because buying a stock or continuing to hold on to a stock involves a much bigger financial outlay than selling a call, put or any other combination of options. A poor or even a mediocre decision can be costly and no amount of writing options will protect against a sudden sharp drop in the value of the stock. It is recommended that you check the financial health of your stocks periodically, read research, and keep abreast of developments in the sector(s) in which the company operates.
2. Determine which option to sell.
The two choices which define an option are the strike or exercise price and the expiry month. Taking the strike or exercise price first.
The higher the strike the more you want for your shares. Of course we would all like to receive a high price however the higher / further away the strike (selling price) from the current price the smaller the premium. Taken to its extreme selling a call for a couple of cents adds little to the overall position other than to cap profits - something we want to avoid.
The following table summarises the different options and premiums on offer for a short dated (1-3 month)options on an average price stock of $10.
In relation to the current share price |
Option |
Premium |
Above the current share price |
Out of the money |
5-20c per share |
At / around the current share price |
At the money |
20-50c per share |
Below the current share price |
In the money |
50c - $1.00 per share |
The second term which defines an option is the expiry month. Covered call writers typically select an expiry date that coincides with their view for the stock. For example if the expectation is for the stock to rise over the next 2 months after which time it will be sold, then a 2 month will be sold. In general covered writers prefer to sell short dated options more frequently than longer dated options less frequently. Short dated options earn premium more on a daily basis than longer dated options, earning sellers more premium.
In order to help determine your potential return from amongst a variety of options check out the covered call calculator.
3. Put the order on:
Call your broker or go online. Most brokers will encourage you to place the order to buy and write as one order, however if you prefer to finesse the order attempting to buy the stock at the low of the day and sell the call at the high you can do this also.
4. Lodge the stock with ASX via your broker as collateral to cover the margin liability arising from writing the call. Your shares need to broker sponsored on Chess for the shares to be accepted.
5. Dividends
Take note of the next dividend and when the stock is going ex dividend. This is vital as call options are usually only exercised early for the dividends on the underlying stock.
6. Buy back the call before the stock goes ex dividend if the option is likely be to early exercised and you don’t want to lose the stock. For more information on why calls are early exercised and the calculation involved.
7. On expiry. The wait is over and your options either expire in, at, or out of the money and the whole process starts over. If you don't want to sell your shares and your options are in the money then you will have to buy back your position. Take note of the expiry dates as after expiry it's too late.
Taken from http://www.asx.com.au/investor/options/how/library/covered_write.htm
When share prices are expected to remain flat, the covered write can be used to generate income, while also providing some protection against an unexpected fall in the market. The strategy consists of writing a call option against shares you hold in the underlying stock.
Payoff diagram
When to use the covered write |
|
Market outlook |
neutral |
Volatility outlook |
steady/falling |
The covered write |
|
Construction |
Buy stock, sell call X |
Point of entry |
market usually around X, but can vary |
Breakeven at expiry |
share price at time of writing option less premium received |
Maximum profit at expiry |
time value component of option premium plus the difference between strike price and share price if option is out-of-the-money when written |
Maximum loss at expiry |
share price at time of writing option less premium received |
Time decay |
Helps |
Margins to be paid? |
no (if underlying stock lodged as collateral) |
Profits and losses
The maximum profit possible from the at-the-money covered write is the premium earned for writing the option. This will be earned if at expiry the share price is at, or above the share price of the call option sold.
The potential loss with this strategy is limited to the price paid for the shares minus the premium, since the investor holds the stock. Any fall in the share price will result in unrealised losses. However, the premium earned on the sale of the option serves to provide some protection from any decline in the value of the shares.
A unexpectedly strong rise in the share price will only incur an 'opportunity cost'. This is because the investor will only receive the option premium and must forgo the increased value of the shares as they will be obliged to sell their shares at the exercise price of the option they have written.
Other considerations
- Strike price: when choosing which option to sell, the trader balances the income to be earned against the possibility that the option will be exercised.
- Writing in-the-money calls will generate the most income and provide the greatest protection in the event of a market downturn. However the possibility that the option will be exercised is high.
- Writing at-the-money options will earn the investor the most time value. The choice of strike price will largely depend on whether the investor's view is neutral leaning to bullish or neutral leaning to bearish.
- Exercise: the writer of a call option must always remember that the option can be exercised at any time. As a result, the investor must be content to lose the stock at that price.
- The buy and write: the buy and write is the simultaneous writing of calls and purchase of the same number of shares over which the options will be written. It represents a method of purchasing stock at levels below the current market price.
- Covered writing can also be done with stock bought on margin.
Points to remember
- Do not use the covered write if you are concerned about being exercised.
- Be sure that you are happy with the price you will obtain for your shares if you are exercised.
- Given the possibility the options will be exercised, be sure that the premium received is adequate compensation.
Example
XYZ shares have had a run up to $4.00 over the last six months.
You believe that the market is quietening down and the stock will remain at these levels over the next three months.
In order to gain some income during this time you decide to write call options over your existing holdings.
It is now September. You sell 1 December $4.00 Call @ $0.41
