A Common Strategy For Enhancing Your Portfolio

Many investors are concerned over potentially weak capital growth in Australian shares for the foreseeable future, and whilst the large cap ASX listed shares pay a fair dividend yield, we often get asked about using Options to generate additional returns.

One strategy that can be quite lucrative for generating additional returns is the “Covered Call” strategy. It involves selling a Call Option over stock that you hold.

When you sell a Call Option, you are selling the purchaser the right to buy the underlying shares at a specific price, at a specific point in time. If you hold these underlying shares, they can be used to fulfill the obligations of the Sold Call.

For example, you may want to sell your CBA shares for $90 each. If CBA was trading around $87.00 a share it is highly unlikely that someone will pay the $90 you are after for your shares.

However, instead of selling the shares, you can sell a $90 Call Option for next month’s expiry. You hypothetically receive around $0.50 per Option for selling these Calls. If you sell these Calls, you have to be prepared to be “exercised”, and sell your stock on CBA for $90.

The big risk for this strategy is if CBA rockets above the $90 level, in which case you will not be entitled to the share price returns above $90, and will still have to sell your CBA shares at $90 (or pay to buy back the Call).

You therefore decide to sell 10 contracts of the below CBA Call Option.

Underlying Security	Strike Price	Expiry	Options Per Contract	Option Price
СВА	$90.00	June	100	$0.50

*Please note that this option is purely hypothetical

Under this scenario, you will receive a credit up front of $500 less costs. (Option price is options per contract X the number of contracts) = ($0.50 X 100 = 10).

Three possible outcomes can eventuate with your Sold Call:

 

1) You buy back the Call Option before expiry, closing your sold call. Under this option, the strategy could generate either a profit or a loss, depending on the credit you received on entry, and the debit you pay on exit.

You may consider this outcome if you now think that CBA is going to continue much higher than your $90 Sold Call. In this way, if your CBA shares rise above $90 in value, you can sell them on market for more than you could if you were exercised on your Sold Call.

You may also consider this outcome if CBA has fallen a bit in share price, and you simply want to take a short-term profit on your Sold Call.

 

2) Your Sold Call expires in the money and you are exercised, selling your CBA shares for $90.00 per share. You will also get to keep the credit you received for selling the Call, meaning that you will receive payments totalling $90.50 per share ($90.00 strike price + $0.50 credit for selling the Call).

This outcome will eventuate if the share price of CBA is above $90.00 on the expiry day. Although you are giving up the opportunity to sell your shares at a greater price than the strike price of the Call, you are selling the shares for more than you were able to when you initiated the strategy.

 

3) Your Sold Call expires out of the money. Under this scenario, your Sold Call will expire worthless, and cease to exist, and you will get to keep the full $0.50 credit for selling the Call.

For many investors using this strategy, this is the ideal outcome. Even though they are prepared to sell their shares, they may be utilising this strategy as a way of generating consistent cash flow each month – selling out of the money Calls as a way to increase the returns on a stock in their portfolio. With a portfolio of optionable stocks, and a consistent application, using Options strategies to enhance your portfolio can be highly rewarding.

Trading options is not suitable for everyone. There is a risk that you can lose more than the value of a trade or its underlying assets. You should only trade if you are confident that you fully understand what you are doing. If you are thinking about acquiring a financial product, you should consult our Financial Services Guide (FSG) at www.reachmarkets.com.au and the relevant Product Disclosure Statement first.