Global has been extensively involved in the derivatives market; trading options and warrants since we began business in 1987. Buying or selling covered puts and calls can mitigate the risk associated with trading an underlying security. However, for the most part they are a leveraged instrument with a finite lifespan.
Global has immediate access to Canadian and US equity options markets through our trading platform, and can facilitate the full spectrum of options strategies for its clients. If you would like more information on trading derivatives please click here for a list of specialized Investment Advisors.
Covered Calls
The sale of a call obligates the seller to sell, at the option of the purchaser of the call, a specific stock within a specified period at a specified price (called ‘the strike price’). The sale of the call is said to be ‘covered’ when the seller of the call owns the stock that will be required to be sold if the purchaser of the call exercises the option.
Covered call writing is either the simultaneous purchase of stock and the sale of a call option or the sale of a call option against a stock currently held by an investor. Generally, one call option is sold for every 100 shares of stock. The investor (ie the seller of ‘writer’ of the call option) receives cash for selling the call but will be obligated to sell the stock at the strike price of the call if the call is assigned. The assignment is carried out automatically, and commission will be charged on this transaction. In other words, under covered call writing, an investor is ‘paid’ to agree to sell their stock holdings at a certain level (the strike price). In exchange for being paid, the investor will necessarily give up any increase in the stock value above the strike price. It should be noted that the investor may repurchase the call if that is advisable.
Who Should Consider Covered Calls?
- An investor who is neutral to moderately bullish on some equities in their portfolio;
- An investor who is willing to limit their upside potential in exchange for some downside protection (by reducing the breakeven cost of the underlying stock); and,
- An investor who would like to be paid for assuming the obligation of selling a particular stock at a specific price.
For an example of a covered call click here.
Cash Secured Puts
The sale of a put obligates the seller to purchase, at the option of the purchaser of the put, a specific stock within a specified period at a specified price (the ‘strike price’). The sale of a put is ‘cash secured’ where the seller of the put has sufficient ready cash to make the purchase if the purchaser of the put exercises the option. If an investor instructs their Investment Advisor to buy a stock at a specified price which is lower than the prevailing market price of the stock, then the investor may have to play the waiting game. The stock will not be purchased until it trades at or below the investor’s limit price. Instead of waiting for that to happen, an investor can sell a cash-secured put. A premium (the price of the option) for selling a put option will be paid to the investor for accepting the obligation to buy a stock the investor wishes to acquire at the price the investor selects.
This strategy is used because it pays the investor for assuming the obligation to buy a particular stock at a particular price for a specified period of time. In other words, an investor who is considering buying a stock (or more or a stock already owned) may want to sell cash-secured puts.
This strategy may involve more inherent risk than the covered call strategy since the investor may eventually acquire a stock which is depreciating in value. The cash-secured put is therefore only suitable for investors with a high-moderate to high risk tolerances.
Who Should Consider Selling Cash-Secured Puts?
- An investor who would like to acquire a position in a particular security, but is willing to wait for it to trade at a desired price.
For an example of a cash-secured put click here.
Risk
Equities option trading involves varying degrees of risk.
Stock ownership entails considerable risk. The maximum risk is that the value of the stock may fall to zero, resulting in the loss of the investor’s entire investment. This is not merely a theoretical possibility; it is the absolute measure of the total risk of loss associated with stock ownership.
If an investor has decided to assume the risk of equity ownership, then adopting a covered call or a cash-secured put strategy will create additional risk factors.
With covered calls, the upside stock appreciation above the strike price will be given up in return for the premium. This premium can be viewed as either income or as partial downside protection, but only up to the amount of the premium. If an investor is unwilling to give up this upside potential in exchange for the call premium, then covered call writing is not a suitable investment strategy for the investor.
With cash-secured puts, the risk is the same as that of equity ownership and must be looked at as a purchase strategy for the underlying equities. The stock that an investor may be obliged to purchase through the put obligation can depreciate in value, and fall to zero. The selling of cash-secured puts must be assessed in risk – reward terms, with the put premium offsetting the stock price decline. If an investor is unwilling to accept the potential price reduction which may occur if the underlying stock is required to be purchased, then cash-secured puts writing is not a suitable investment strategy for the investor.
|
