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Selling your securities by writing covered call options

Martin Noël
August 24, 2020
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Selling your securities by writing covered call options

Let us say you are willing to sell some securities in your portfolio, or you are considering it. Adopting the covered call writing strategy is like getting paid for making a commitment to sell the securities.

This is the second in a series of four articles on covered call writing. It discusses how to use this strategy as an alternative to selling securities directly on the Toronto Stock Exchange.

 

To sell some shares

An investor would like to sell 100 shares of stock XYZ at a price of $35/share over the next 30 days. The shares are currently trading at $33. Based on her analysis, the investor believes that the stock has limited potential to rise above $35 and would like to use the cash generated by the strategy to buy another security that seems to have more potential.

 

Toronto Stock Exchange
30-day order placed on XYZ, which is currently trading at $33
Sell 100 XYZ shares at $35/share

 

She therefore places a limit sell order on the Toronto Stock Exchange. Her order to sell 100 XYZ shares at $35 is valid for 30 days. With this order she agrees to sell her shares if at any time in the next 30 days XYZ starts trading at or above $35. However, she recently attended an introductory webinar on options where she learned that selling a call option obliges the seller to sell the underlying shares if the holder of the option exercises his or her right to buy. In exchange for this obligation, the seller of the call option receives a premium, which can be kept regardless of whether or not the call option is exercised by the holder.

 

Toronto Stock Exchange Montréal Exchange
30-day order placed on XYZ, which is currently trading at $33 Order placed on a call option on XYZ expiring in 30 days and with an strike price of $35
Sell 100 XYZ shares at $35/share Write 1 call option on XYZ at a $35 strike for $1.00

 

The investor therefore decides to place a sell order on the Montréal Exchange on an XYZ call option expiring in 30 days with an exercise price of $35. The call option is written for $1.00 per share, for a total of $100 ($1.00 per share x 100 shares per option). In exchange for this $100 premium, the investor agrees to sell her shares at $35 if the holder of the call option exercises it. In this case, the effective selling price will then be $36/share (the strike price of $35 + the $1 premium).

 

Table comparing the direct sale of shares with writing a covered call option
Price of XYZ in 30 days Profit (return) on selling the shares on the Toronto Stock Exchange Profit (return) from implementing the covered call strategy on the Montréal Exchange
$38 $200 (or 6%) [($35 – $33) x 100] $300 (or 9%) [($35 – $33 + $1) x 100]
$35 $200 (or 6%) [($35 – $33) x 100] $300 (or 9%) [($35 – $33 + $1) x 100]
$33 $0 (or 0%) [($33 – $33) x 100] $100 (or 3%) [($33 – $33 + $1) x 100]
$32 -$100 (or -3%) [($32 – $33) x 100] $0 (or 0%) [($32 – $33 + $1) x 100]
$30 -$300 (or -9%) [($30 – $33) x 100] -$200 (or -6%) [($30 – $33 + $1) x 100]

 

As the above table shows, under each scenario the writing of a covered call option generates a higher return than simply selling the shares on the market of the Toronto Stock Exchange. In fact, if the price of XYZ in 30 days is greater than or equal to $35,[1] the investor will have sold her shares at $35. The same applies to the call option, because it will then be in the holder’s interest to exercise it, in order to buy the shares at a price that is lower than the market price. The result is a profit of $200 or 6% for selling the shares directly and a profit of $300 or 9% for selling them through the covered call option. In the event that the price of XYZ remains unchanged at $33 after 30 days (and assuming that the stock has not traded above $35 in the interim), the investor will not have sold her shares on the Toronto Stock Exchange or through the call option, since it will not be in contract holder’s best interest to exercise it and pay $35 for the shares when they can be bought directly on the market for $33. In the case where the stock price falls, writing a covered call lowers the break-even point to $32, while simply selling the shares generates a loss of $100 or -3%. Lastly, we can see that all the downside scenarios show that writing a covered call reduces the investor’s loss by $100. This difference is due to the $100 premium collected from writing the call option.

 

Conclusion

Covered call writing is a strategy that can be used to offer securities for sale when you believe that they have limited potential for posting further gains. By writing one call option contract for every 100 shares held, the writer of the options collects a premium that can be kept, regardless of whether the holder of the call options exercises them. In exchange for this premium, the seller agrees to sell the shares at the selected strike price if the holder of the options exercises the right to purchase them. In the event that the options are not exercised before they expire, the holder of the securities may decide to write more covered call options. In the next article, we will discuss how to generate income either on an ad hoc basis or systematically by writing covered calls.

Before you start using the strategies mentioned in this article, we suggest that you test them using the Montréal Exchange’s trading simulator.

Good luck with your trading, and have a good week!

 

The strategies described in this blog are for information and training purposes only. They should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.

[1] To be sure that the shares are sold at $35 on the Toronto Stock Exchange or the Montréal Exchange, the price would have to be $35.01. For the purposes of this article, we assume that the shares will be sold on the Toronto Stock Exchange and that the holder of the call options will exercise them.

Martin Noël
Martin Noël http://lesoptions.com/

President

Monetis Financial Corporation

Martin Noël earned an MBA in Financial Services from UQÀM in 2003. That same year, he was awarded the Fellow of the Institute of Canadian Bankers and a Silver Medal for his remarkable efforts in the Professional Banking Program. Martin began his career in the derivatives field in 1983 as an options market maker for options, on the floor at the Montréal Exchange and for various brokerage firms. He later worked as an options specialist and then went on to become an independent trader. In 1996, Mr. Noël joined the Montréal Exchange as the options market manager, a role that saw him contributing to the development of the Canadian options market. In 2001, he helped found the Montréal Exchange’s Derivatives Institute, where he acted as an educational advisor. Since 2005, Martin has been an instructor at UQÀM, teaching a graduate course on derivatives. Since May 2009, he has dedicated himself full-time to his position as the president of CORPORATION FINANCIÈRE MONÉTIS, a professional trading and financial communications firm. Martin regularly assists with issues related to options at the Montréal Exchange.

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