PROBLEMS WITH COVERED CALL WRITING

In last month's newsletter the effect of falling option volatility was highlighted which led to historically cheap option prices. So if options are being priced with their smallest premiums in years, is it worth selling call options against shares owned, so called Covered Calls?

For an introduction to Traded Options Click Here

What Is Covered Call Writing?

Covered Call writing is where an investor owns a stock and sells call options short to try and pick up a further yield. For example;

• Buy 1,000 shares of Standard Chartered at £9.09, and
• Sell short 1 Dec £10.00 call receiving a credit of £0.125 per 1,000 shares (£125)

• If the shares rise above £10.00 they will be called off you at that price
• But it's not all bad news because your profit will be £0.91 (share price rise) + £0.125 (option sale) = £1.035 or 13.86% in less than 6 months
• If the shares do not rise above £10.00 then you'll keep ownership alongside the £0.125 per share that was received for the selling the call option
• The best result is therefore for the shares to settle at exactly £10 on the December options expiry date because then you keep both the shares and the options premium

But is it really worth selling the right to sell shares at £10.00 and only receiving a paltry £0.125, which equates to an extra 1.37% of the original share purchase price? Most probably not. The cheapness of the options is due to the very low option volatility. A year or two back these same call options may have been worth triple or even quadruple the present day prices so selling calls against stock then was far more lucrative.

This is why investors shouldn't box themselves into a corner following the same strategies in all types of markets. If you talk to an options broker he'll report that many of his clients who in the past have been active covered call investors have now backed off because it's just not worth selling options that are this cheap.

A covered call trader is by nature bullish because he first has to buy the stock and call options should only be sold as an afterthought. So if the prices for options aren't attractive then wait patiently, which in the case of this present market may well be many months if not into 2005.