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The Lowdown On Covered Call Options

The Lowdown On Covered Call Options

Covered call writing is a strategy used to generate extra income from stock already held in an investor's portfolio.

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By Expert Panel 21.05.2012

By Stephen Karpin, CommSec 

Question:

I am looking for information on covered call options,

-          Who or what sets the call premium  on a particular share

-          Can I use any e- broker or is it only some brokers. 

-          What is the usual broker cost

-          Any possible down side for shares I already have in my portfolio.

 

Response:

Covered call writing is a strategy used to generate extra income from stock already held in an investor’s portfolio.

How it works: An owner of stock will “write a call” and receive a premium for doing so.  Writing a call means that they have sold a call which entails an obligation, up to a certain date, to sell their stock at a pre-determined price to the other party, the option buyer.  The predetermined price (the strike price) is usually slightly above the current trading price allowing the ‘writer’ an additional capital growth and income component.  If by the option expiry date, the stock price has not surpassed the strike price, then the owner of the stock would not usually get exercised and hence will be able to keep their stock.

The premium received for writing a call is determined by various factors such as the strike price, the time till expiry and the volatility of the underlying stock which are then fed into an options pricing model.  From first principles, the longer the time till expiry, and the lower the strike price, the higher the option premium received.  (Think of this much like someone selling insurance on a price rise).  Another key factor is the volatility of the stock and the higher volatility, the higher the option price. Further to this, ETO market makers are obliged to create and maintain a market for participants to trade as a way of offering liquidity.

There are a range of online brokers that offer covered call writing as part of an options trading account.  As per ASX rules, after a call is written, the stock is reserved at the Options Clearing House (ASX Clear) as collateral against the obligation.  CommSec charges $34.95 or 0.35% incl GST for online options trades whilst also offering dynamic trading tools including charts, research and covered calls over stock held on margin loans.

Some precautions should be kept in mind when writing covered calls.  The seller may be exercised before expiry and lose out on upcoming dividends.  This early exercise is more likely if the written call is in the money. One other disadvantage of writing call options against stock you own is the capping of upside capital growth beyond the strike price of the written call.  


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Important Information

The views expressed in this article are those of Brian Phelps, a representative of Commonwealth Securities Limited (CommSec) ABN 60 067 254 399 AFSL 238814.  Commonwealth Securities Limited (CommSec) is a wholly owned but non-guaranteed subsidiary of the Commonwealth Bank of Australia ABN 48 123 123 124 and a Participant of the ASX Group and the Sydney Futures Exchange. As this information has been prepared without considering your objectives, financial situation or needs, you should, before acting on this information, consider its appropriateness to your circumstances and if necessary, seek appropriate professional advice.

CommSec Margin Loan is a facility provided by Commonwealth Bank of Australia and is administered by CommSec. Please be aware that a CommSec Margin Loan exposes you to unfavourable movements in the value of shares and units in managed funds, and possibly to margin calls. Please be aware that you are personally liable for any shortfall that occurs should your entire portfolio have to be sold to answer a margin call where there have been falls in the market value of your investments. Only investors who fully understand the risks associated with gearing into investments should apply. All applications for a Margin Loan are subject to the Commonwealth Bank’s credit approval process. Fees and charges apply.

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