Selling Your Securities by Writing Covered Call Options

20 November 2020 by Montreal Exchange
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Are you ready to sell securities you own or considering doing so? Adopting the strategy of selling covered calls is like being paid to commit to selling your securities.
In this article, you’ll learn how investors can use the strategy of selling covered calls instead of selling shares.  
 

Comparison of the two types of strategies

Let’s take the example of an investor who, in the next 30 days, wants to sell 100 XYZ shares at $35 while they are trading at $33. According to his analysis, he believes that the potential for an increase above $35 is limited and would like to use the cash generated to buy another stock that has more potential. However, he recently learned, during an introductory options webinar, that selling a call option required the seller to sell the underlying shares if the option holder exercised his right to purchase. In return for this obligation, the seller of the call option receives a premium that he can keep, regardless of whether the call option is exercised or not by the holder.

He will therefore have the following two choices: 

  1. Place a 30-day limit order to sell 100 XYZ shares for $35. 
    In doing so, he agrees to sell his shares if at any time within the next 30 days the price of XYZ shares reaches or exceeds $35.
  2. Place a sale order on a call option for XYZ expiring in 30 days with a strike price of $35 for a premium of $1.00 per share for a total of $100 ($1.00 per share × 100 shares per option contract). 
    In exchange for the $100, he agrees to sell his shares at $35 if the holder of the call option exercises it, in which case, the sale price will then be $36 (strike price of $35 plus $1 premium).

Comparison table of results between directly selling shares and selling a covered call option

  Selling without an options strategy
Submitting an order to sell 100 XYZ shares at $35 valid for 30 days
Selling with an options strategy
Sale for a premium of $1 of an XYZ call option with a strike price of $35 expiring in 30 days
Price of XYZ in 30 days Result from the sale of the shares
Result of the strategy of selling a covered call option
$38 $200 (or 6%): [($35-$33) × 100]
$300 (or 9%): [($35-$33 +$1) × 100]
$35 $200 (or 6%): [($35-$33) × 100]
$300 (or 9%): [($35-$33 +$1) × 100]
$33 $0 (or 0%): [($33-$33) × 100] $100 (or 3%): [($33-$33+$1) × 100]
$32 -$100 (or -3%): [($32-$33) × 100] $0 (or 0%): [($32-$33+$1) × 100]
$30 -$300 (or -9%): [($30-$33) × 100] -$200 (or -6%): [($30-$33+$1) × 100]

 

In any case, as the table above shows, selling the covered call option generates a higher return than simply selling the shares on the Toronto Stock Exchange.

  • Indeed, if the price of XYZ in 30 days is greater or equal to $35 , the investor will then have sold his shares at $35. The same applies to the call option, since it will then be in the holder’s interest to exercise it to buy the shares below the market price. The result is a profit of $200 or 6% for simply selling the shares and a profit of $300 or 9% for selling the covered call option.
  • If XYZ’s price remains stable at $33 at the end of the 30-day period, assuming that it has not exceeded $35 in the interim, the investor will not sell his shares either through the limit order or the call option, since it will not be in the interest of the option holder to exercise his right to purchase and pay $35, when he can buy the shares at $33 directly on the market. 
  • In the event of a price drop, selling a covered call option lowers the break-even point to $32, while simply selling the shares generates a loss of $100 or 3%.

Finally, we can see that, in all declining price scenarios, selling a covered call option reduces the loss by $100. This difference is due to collecting the $100 premium following the sale of the call option.

Conclusion

The strategy of selling covered call options can be used to sell securities if you believe that the upside price potential is limited. By selling a call option contract for every block of 100 shares held, the seller of the option collects a premium that he can keep, regardless of whether the call option holder exercises it or not. In return for this premium, the seller agrees to sell his shares at the agreed upon strike price if the option holder exercises his right to purchase. If the option is not exercised before it expires, the holder of the shares may sell other covered call options if he still wants to. 

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