Transcript: CIBC Investor’s Edge - Generating income with options

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CIBC Investor’s Edge employee: Hello and welcome to Investor’s Edge. In this video, we're going to explore covered call writing. What is it and how can you best execute this strategy in your portfolio? In our previous video, we examined the payoff of buying a call. 

[Graphic titled “Contract”. Below is an icon of a signed document and above the icon is the label “Gives the right”. To the right a coin icon with arrows coming out in both directions appears labelled “to purchase a stock”. To the right of this, “at a strike price” with an icon of a dollar with a checkmark below. This last icon changes to a calendar labelled “until the contract expires”.]

If you recall, as a call option buyer, you enter the contract and pay a premium for the right to buy a stock at the designated strike price until expiry.

[Graphic titled “Call option seller”. Below an icon of a dollar with a curved arrow below labelled “Receive a premium up front”. Below an icon of a bar graph and an arrow trending upwards appears and is labelled “In exchange for the obligation to sell shares of the underlying company”. Below an icon of a checkmark appears and is labelled “If the call is exercised”.]

Now, we're going to look at the other side of the trade from the perspective of the call option seller or writer. This is where we receive a premium upfront in exchange for the obligation to sell shares of the underlying company should the call be exercised. 

[Icon of a bar graph and an arrow trending upwards and above, labelled “Combine ownership of a stock”. Beside it, an icon of a signed document and pen and above labelled “with selling or writing a call against it”.]

So what is a covered call? This is a strategy where we combine ownership of a stock with selling or writing a call against it. In other words, long stock, short calls. We either have shares of the company already or we go out and purchase the shares in the open market, generally prior to writing the call options. 

Imagine you own 500 shares of XYZ Inc. in your portfolio. You've been holding the stock for a while and have been looking for ways of generating additional income.

[Icon of a signed document and pen and above, labelled “Sell 5 XYZ calls (500 shares)”. Beside it is an icon of a dollar with a checkmark, and above, labelled “at selected strike price”. To the right of this is an Icon of a calendar beside that and above labelled “and selected expiry date”.]

In this case, you may choose to sell 5 XYZ in calls at your selected strike price and expiry date. If the call option is exercised, you will have to sell your 500 shares. 

[Graphic titled “575 shares”. Below is an icon of a signed document and pen and above, labelled “each option contract 100 shares”. Beside it is an icon of a bar graph and an arrow trending upwards and above, labelled “round down from 575”. The label then changes to: “round down to: 500”. Finally another icon appears of 3 boxes stacked on top of each other, labelled above “75 shares odd lot”. The entire graphic then changes to “575 shares = 5 contracts”.]

Now, what would happen if you owned 575 shares? Would you be able to write more than 5 calls? Since each option contract represents 100 shares, you must round down to the nearest 100 to figure out how many contracts you can actually write.

In this example, the 75 shares is considered an odd lot, so you can only write calls against 500 shares or sell 5 contracts. 

[Graphic titled “Writing a covered call advantages”. Icon of a dollar with a curved arrow under it and beside it the following label: “Income is generated immediately for other investments, retirement, or vacation”. Another icon appears below, of a bar graph and an arrow trending downwards, labelled “Provides some downside protection”. Another icon appears below, of a dollar with a checkmark, labelled “Possible to turn a profit without any increase in the underlying stock price”.]

As a covered call writer, what’s in it for you? 

For starters, income is generated immediately and you may use this cash flow for other investments to help fund your retirement or perhaps contribute to your next vacation. 

Secondly, it provides some downside protection by reducing the breakeven value on the trade. 

Lastly, you may turn a profit without any increase in the underlying stock price. While you may buy back your calls at any point throughout the term of the contract, covered calls tend to be held until expiration. The reason why? Because as an option seller, time is on your side.

[Graphic titled “2 components of an option premium”. Below is an icon of an unfolded document, labelled “Intrinsic value”. Below this an icon of a clock appears, labelled “Time value”. The clock icon is then highlighted and everything else moves off-screen. Below an icon of a dollar with a curved arrow underneath, labelled “Generates profits for you”. Below this an icon of a graph with a graph arrow curving downwards, labelled “Erodes to zero at an accelerating rate”. Everything below the clock icon, then slides off-screen. Icon of a calendar with flipping month pages, labelled “If we hold until expiration”. Below label, two points are highlighted individually: “Option is exercised”, “Option expires worthless”.]

If you remember from our previous video, there are two components of an option premium. Intrinsic value and time value. Time value is the portion that generates profits for you. And we know time value erodes to zero at an accelerating rate. If we hold till expiration, we will either be assigned on our contracts and have to sell our shares, or the option expires worthless and we get to do it all over again.

[Graph titled “Stock XYZ trading at $12”. Graph starts at $8 and goes up by $2 to end at $16. The graph line starts at $10 and fluctuates moving up to $12. This is highlighted by a dotted line, labelled “purchase”. Beside the graph is an explanation: “Purchase 1,000 shares $12/share = $12,000”. Another dotted line appears at the $13 mark, labelled “strike price”. Below the explanation, the following is shown: “Sell 10 $13 calls”. Below this the explanation is: “$1/contract = $1,000”. A minus sign appears beside the $12,000 and a plus sign appears beside the $1,000. Below an explanation of this is: “Breakeven value. Reduced to $11,000”.]

Now, let’s look at an example. Here we buy 1,000 shares of Company XYZ for $12 a share. We sell 10 of the $13 calls that will expire in six months at a price of a dollar. We immediately have positive cash flow of $1,000 by writing the call, which adds to the $12,000 outflow for purchasing the stock, thus reducing our breakeven on the trade to $11,000.

[Graph titled “Scenario 1: stock XYZ at $12”. Graph starts at $8 and goes up by $2 to end at $18. A fluctuating graph line starts at $11 and ends at $12. A dotted line at that point, labelled “purchase”. Beside the graph an explanation is shown: “Purchased 1,000 shares @ $12/share”. Another dotted line appears at the $13 point, labelled “Strike price”. To the far right an explanation is shown: “Sold 10 calls @ $1 ($13 strike price)”.]

[Graph title then changes to “Scenario 1: stock XYZ at $18 on expiry”. The graph line extends further and ends at $18.The previous explanation disappears and changes to an arrow from the purchase price up to $18 and indicates: “stock only strategy”. The area between the “purchase” dotted line and the "strike price” dotted line is labelled “covered call strategy”.]

What will happen next? Well, let's look at some scenarios. So we bought our stock at $12 and sold our call for a $1 premium. 

What happens if the stock was up a lot during the six-month period and say it closes at $18? You can see that you would have been much better off not writing the call as the stock is up 50% compared to your maximum return, which is just shy of 17%.

Graph is shown, but the explanation changes to indicate that the “strike price” point “Must sell for $13”. The difference between the “strike price” point and the “purchase” point is labelled “$1 appreciation on the shares”. The “strike price” is also labelled to indicate “$1 premium collected”. The difference between the “strike price” and the expiry price is labelled “Large opportunity cost”.]

Why is that your maximum return? Well, if the shares are trading above the strike price at expiry, you'll be a sign on the calls and are obligated to sell the stock for $13. There is $1 appreciation on the shares from $12 to $13, plus the dollar premium we initially collected. 

In this scenario, the opportunity cost of using the covered call strategy versus simply holding the stock is actually quite significant.

[Graph now titled “Scenario 2: stock XYZ at $13 on expiry”. The graph line changes to indicate the expiry price is $13. The difference between the “strike price” point and the “purchase” point is labelled “Maximize the price appreciation potential”. Below a further explanation: “Don’t have to sell shares”. Another explanation point says: “$1 premium collected”.]

The optimal outcome for us is if the stock closes at $13 on expiry because we get to maximize the price appreciation potential of the trade without having to sell our shares. That appreciation is in addition to the premium we collected. 

[Graph is now titled “Scenario 3: stock XYZ at $12 on expiry”. The graph line changes to indicate the expiry price is $12. The difference between the “strike price” point and the “purchase” point is labelled “$1 premium collected”.]

Now, if the stock does not move and closes at the $12 price we purchased it at, the return generated is simply equal to the cash flow yield from the premium.

[Graph is now titled “Scenario 4: stock XYZ at $11 on expiry”. The graph line changes to indicate the expiry price is $11. The explanation indicates “$1 premium collected”. Below a further explanation says “Lowers the breakeven price on the trade”.]

If the stock is down a little, you may still turn a profit because as we mentioned earlier, the premium lowers the breakeven value of the trade. 

[Graph is now titled “Scenario 5: stock XYZ at $8 on expiry”. The graph line changes to indicate the expiry price is $8. An arrow is shown from the “purchase” price to the “expiry” price and the explanation says “Won’t protect from a significant downward move”.]

This highlights the downside protection component of the strategy, but it won’t save you from a significant downward move in the stock price. From these scenarios, you can see the sweet spot for a covered call writer is slightly positive to flat stock performance.

Thank you for watching and happy trading.

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[CIBC Investor’s Edge is a division of CIBC Investor Services Inc. This document is provided for general informational purposes only and does not constitute investment advice. The information contained in this document has been obtained from sources believed to be reliable and believed to be accurate at the time of publishing, but we do not represent that it is accurate or complete and it should not be relied upon as such. All opinions and estimates expressed in this document are as of the date of publication unless otherwise indicated, and are subject to change. The CIBC logo is a registered trademark of CIBC. The material and its contents may not be reproduced without the express written consent of CIBC.]

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