The search for income is constant for those in retirement and those wishing to retire. Apart from the usual bank deposits, superannuation income streams and share dividends there’s not much more you can do, short of delivering pamphlets door to door!
There are, however, alternatives although somewhat outside of the mainstream to consider. So for anyone wanting to be a little more adventurous, writing a call option is the answer.
Call options or Covered calls
Normally, investors wait for dividend cheques every six months and for the rest, their shares re- main in the proverbial bottom drawer. Well go and dig them out because, with a little know-how, you can extract money from them every month. (Oh, and this strategy is also suitable for SMSF’s, so take note trustees.)
It’s done by selling a Call Option, which is a member of the options ‘family’. Put simply, selling a call option means you are forfeiting your right to sell your shares, and getting cold, hard, cash in re- turn. This strategy is more correctly termed a covered call strategy as the word ‘covered’ refers to the fact you have actual ownership of the shares you are contracting to sell.
You may hear the term ‘naked’ call option which means that you do not actually own any of the shares you are contracting to sell. This is a far more risky strategy and isn’t at all suitable for long- term investors. Alternatively, the covered call strategy is viewed completely the opposite and is seen as a very conservative income producing investment strategy.
What exactly do I sell?
The buyer of the call option will be buying the right, but not the obligation, to purchase your shares at a predetermined price on a future date. This sale price is referred to as the strike price. The call option remains open, up to its expiry date when it is either exercised (acted on) or expires worthless.
Confusing? It will be when you first learn about it, but once you get the hang of it, it gets easier.
The benefits of the transaction
To illustrate how all this works, let’s assume you’re holding 5000 ABC shares currently priced at $10 each. You decide to sell a call option with a strike price of $16 expiring in 60 days.
First and certainly foremost, you receive a premium (the price of the call option) from the buyer. Now, this is the income generated from your otherwise “dormant shares” It is yours to keep no matter what transpires when the call option expires. Importantly, you calculate the premium or sale price with consideration to a number of market variables.
You are actually endeavouring to entice a buyer with a realistic option price yet you are hoping they don’t actually proceed with the ultimate purchase. As you can see there is a certain ‘art’ to the pricing.
Therefore it’s a good idea to seek professional guidance for your first couple of transactions so you can determine an attractive option price. Although there are online calculators that can help you arrive at a competitive strike price. Just search for option pricing calculators.
For our example, I have set the premium at $1 per share. Because you own 5,000 shares; you will immediately receive the sum of $5,000 from the prospective buyer. This income is generated each time you write a call option. Therefore with a 30-day expiry, you can effectively write a new option each month for as long as you hold the shares. Now that’s what you call income generation!
Ok, having just sold the right to sell your shares, via the call option, the only person who is now entitled to buy those shares, is the purchaser of the call option. And they remain in that position whilst ever the option stays current.
This buyer has also agreed to purchase the shares for $16 each. So no matter what the current market price for your shares are at the time the call option expires, you will be paid $16 per share. Keep in mind though; the buyer is not obligated to purchase your shares, only you are obligated to sell them should the buyer want them.
Reasons to write a call option
Alright, so far so good. Let’s now look at why you would do such a transaction. In reality, you really don’t want to sell your shares. But you just gave someone the right to buy them in the future. Well, it just so happens that the call option buyer may not end up buying them if you have done your pricing correctly. Currently, your shares are $10 apiece and the agreement is for $16 apiece.
Now the reason someone buys this option is that they believe, the shares are currently undervalued and will go up. But they can’t be certain. So to avoid outlaying huge sums of money, on a hunch, they outlay a fraction of the cost to buy a call option.
Therefore, the buyer of your call option is of the belief that ABC shares will go past $16 at some point over the duration of the option. And they have now locked in your shares if and when that occurs. So instead of tying up lots of money purchasing the shares outright, they have used an options strategy.
On the other hand, the seller of the option (you) believes the exact opposite is going to happen. The share price of ABC will remain flat or even go down.
It’s all about the price
The transaction is all about setting the right sale price of the option. This is where the ‘know how’ is needed. The desired outcome for you is for the call option to just expire. This will mean you keep your shares, plus, pocket the premium received for selling the option.
On the other hand, should your call option be exercised, you will have to sell the shares. But you are selling at a higher price than when you sold the option and also have the sales premium. So you are certainly ahead money wise, except, of course, you now don’t own the shares.
By the way, if it looks like your option will be exercised as the price of your shares is suddenly skyrocketing, don’t worry. If you want to keep the shares you just buy another option to cancel yours out, so all is not lost.
Now I know all of this sounds somewhat complex. I do though recommend you conduct your own re- search on this topic and seek out advice. So if you have some shares that are just in the ‘bottom drawer’ a call option strategy may be a very good way to increase your portfolio’s income
And remember, always get professional advice, so talk to your financial adviser or broker before you do anything.
Thanks for reading and I look forward to seeing you here again. Homepage
