KEY AREAS

• Options Introduction
• Options Overview
• Why use Options?
  • Traders versus Investors
  • Basic Uses
  • Covered Call Writing
  • Insurance
  • Tax Planning
  • Trading Examples
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Covered Call Writing

Options are perceived as high risk investments. They were developed, however, as a way of reducing risk for producers and buyers of raw materials. A farmer growing wheat who can secure a price for his crop at the time of planting is taking less risk than the farmer who waits until the crop is harvested as the latter is subject to fluctuations in the price of his crop during the growing period.

Options by themselves are not high risk. It is the way in which they are used that determines the risks taken.

In the case of a covered call, the investor holds the underlying asset and assumes an obligation to sell that asset at a premium to the current market price. For that obligation the investor receives a cash payment now, which may provide an element of downside protection.

For example

• Client holds 2000 shares, currently 1250p (Asset worth £25000)
• Client writes(or sells) 2 (each contract is 1000 shares) JULY 1300 calls @ 53p receiving £1060 now.
• Net value of the position is now 25000-1060 or 23940 or 1197p per share.
• The client has taken on the obligation to sell his 2000 shares at 1300 at any time between trade date and July 16th , 100 days from now.

There are two possible outcomes to the trade and we will compare this with the position of the shareholder who just holds the stock alone.

• Stock below 1300pWriter has reduced his risk to the stock by the amount of premium received. 53p equates to either 1.3 times the annual dividend for this stock for only 100 days or serves as a discount to the cost price of 4.2%(53/1250)
• Stock above 1300pThe obligation to sell the stock is exercised and the client sells 2000 shares at 1300p raising £26000. This represents a return on the initial investment of 8.6% (26000/23940) over 100 days or 31.4% annualised.

THE USER OF OPTIONS IN THIS CASE HAS ASSUMED A LOWER RISK POSITION THAN THE HOLDER OF THE UNDERLYING STOCK BECAUSE THE PREMIUM RECEIVED PROVIDES AN ELEMENT OF DOWNSIDE PROTECTION.

If the above strategy is applied to a portfolio of shares it may help to secure more predictable returns from the investments.

Note

The above information is provided for illustrative purposes and should not be relied upon in making any investment decision, portfolio review or any other decision. No warranty or accuracy is given and you should obtain relevant and specific professional advice.