Explore Your Options - Part Three

Peter Katevatis - Aug 04, 2015
This is the thrilling conclusion of Explore Your Options, a discussion on exchange traded equity options.  If you would like to review the first two, here is Part One and Part Two. After explaining the Call option then the Put option, here are som

This is the thrilling conclusion of Explore Your Options, a discussion on exchange traded equity options.  If you would like to review the first two, here is Part One and Part Two.

 

After explaining the Call option then the Put option, here are some common strategies investors use to lower their risk and (hopefully) increase their return.

 

The Covered Call is a basic strategy for the moderately bullish investor.  Generally this is used to add to the income generated from an existing dividend paying company.  The investor would own shares in a company then sell call options and keep the premium.  There are two potential outcomes on maturity:

 

  1. The shares have stayed flat or moved down and the call option expires worthless.  You keep the premium and you are free to sell another call option.
  2. The shares have moved up above the strike price on the call option and you sell your shares (called out) at that price.  You can then re-buy the shares or move on to another investment.

For example, if an investor holds 1,000 shares of Royal Bank they would earn the current 4% dividend.  With the shares trading $76.25 an investor could sell 10 $78 strike August calls for $0.40 or $400.  If they were able to repeat the process 12 times over the year it could add 6.3% to the yield for a total cash yield of over 10%.

 

However, the biggest difference would be the volatility.  With high volatility (which we do presently have) Royal Bank options trade with a higher premium.  By selling calls, the investor collects that premium.  If the Canadian economy and worldwide banking had a rosy outlook, the volatility premium on Royal Bank would shrink possibly making a covered call strategy unattractive.

 

Selling a call (or a put) is best when you have volatility.  Usually this is event driven and you can profit from fear or excessive speculation.  General rule of thumb: when the VIX is high, sell options to keep the extra premium.

 

Protective Puts are another simple strategy which creates an efficient customized insurance policy.  If you plan on holding a position but you have a short term concern you can buy an out-of-the-money put option to lock in a specific value or cover potential losses.  You can buy the right amount of puts to offset 100% of the potential losses or even 50% (or less) if you don’t want maximum protection.

 

There are two potential outcomes to a 100% protective put.

 

  1. The shares maintain the current level or rise.  You keep your existing share position and your puts expire worthless.  Basically, your average cost will have risen slightly (cost of the put) but all else remains the same.
  2. The shares drop in value below your strike price and your losses from current levels are covered.  In this instance you can sell your puts for a profit to offset your equity loss or you can exercise your right to sell and cash in your shares at the price of your put.  Either way the net benefit should be the same.

Protective puts are particularly effective when volatility is low.  You don’t have to pay a high “premium” for your protection/insurance.

 

Both of these strategies are particularly effective in RRSP/RRIF accounts to minimize any tax issues from being “called out” or if you exercise your put option.  If you want some more detailed information on Covered Calls or Protective Puts, please do not hesitate to ask

 

Both of these strategies are designed to keep your investments growing but protect your assets in a falling price market.