Covered Calls offer a great way for investors to generate extra cash flow in their portfolios. Previously, the only cash flow in a portfolio would have been in the form of dividends or interest payments. Recently, however, Covered Calls have become amongst the most commonly used and simplest internationally available cash-generating option strategies.
A Covered Call is an option strategy where you sell call options over shares you own. The buyer of a call option then has the right, but not the obligation, to buy shares at a specified price on a specific date in the future. For example, if we are the buyer and you are the seller, you will have an obligation to deliver your shares to us at the Covered Calls strike price. You get to choose the strike price at the time the covered calls are traded.
You are essentially agreeing to give up any gains past the Covered Call’s strike price. To compensate you for potentially losing out on upside, you’ll receive option premium in the form of cash.
Are Covered Calls right for you?
A Covered Call strategy is something you may consider if you hold shares in a company and:
- would like to generate extra yield or cash flow your portfolio;
- have a neutral view on the share; and
- are willing to sell your shares at your chosen share price or give up any upside above that price.
In return for foregoing potential upside in your shares, you’ll receive cash in the form of option premium. While you hold your shares, you will still receive all dividends that the underlying share pays.
An option for generating cash flow – or simply an alternative to selling
Covered Calls can also be used as an alternative to you selling your shares outright. Let’s look at a practical example.
An investor, let’s call him John, has been holding Naspers (NPN) shares he purchased at about R1,500 and has made a healthy return, as they are currently trading at roughly R2 100. The investor would like to sell his Naspers shares when they eventually reach R2 300.
Ordinarily, John would have to wait for the shares to reach R2 300 so he could sell his shares. Instead of waiting for Naspers to reach R2 300, however, John decides to sell Covered Calls over his shares. John chooses to sell calls with a strike price of R2 300 that are set to expire on 14 June 2017.
At the time of writing this article, the Covered Call premium John receives is R114 per option contract (per share). This premium goes into his trading account the day John sells his Covered Call. If you look at the Covered Call premium of R114 as a percentage of the share’s value, it’s a 5.5% yield (100 / 2 100) to 14 June 2017 (roughly 159 days away). Annualise this amount and it works out to 12.50% per annum. The investor’s maximum return will now be capped at the Covered Calls strike price plus the option premium received. This means gains in Naspers up to R2 300 + R114 option premium received.
If Naspers closes above R2 300 on 14 June 2017, the investor delivers shares to the bank (the buyers) at R2 300; if Naspers doesn’t reach R2 300 John keeps his shares, and his Covered Call simply expire. The investor can then repeat the process of selling Covered Calls by selling calls to the next maturity in September 2017. John keeps his R114 Covered Call premium regardless of what happens to Naspers.
How to sign up for Covered Calls
You can register now by logging onto your online share trading account at securities.standardbank.co.za. Then, under “My Account” go to “Product Registration” and select “Option Strategy registration”.
You will find the full brochure and extra articles written on the subject by selecting “Help”, then “Downloads” then “Option Strategies”.
We’ve also put together a video about Call Covers that you may prefer to watch. Click here to view it now.
