My name is Mark Goodfield. Welcome to The Blunt Bean Counter ™, a blog that shares my thoughts on income taxes, finance and the psychology of money. I am a Chartered Professional Accountant and a partner with a National Accounting Firm in Toronto. This blog is meant for everyone, but in particular for high net worth individuals and owners of private corporations. The views and opinions expressed in this blog are written solely in my personal capacity and cannot be attributed to the accounting firm with which I am affiliated. My posts are blunt, opinionated and even have a twist of humor/sarcasm. You've been warned. Please note the blog posts are time sensitive and subject to changes in legislation or law.

Thursday, May 26, 2011

Covered Calls

Investors are always looking to reduce their risk in owning a specific stock. One method to reduce that risk is to use a covered call strategy.

Selling covered calls is a strategy in which an investor sells a call option contract while at the same time owning an equivalent number of shares in the underlying stock. It is considered to be one of the safest option strategies in the market.

In simple terms a covered call means you sell a call option to another investor which entitles them to purchase a stock you already own at a specified price. The concept is best illustrated by an example.

You purchase 100 shares of Research and Motion for $58/share and agree to sell it for $60 on the third Friday of the following month.  You receive $4/share for selling this call option. The return calculation is as follows:

Cost of 100 shares at $58/share                        $   5,800
Call premium received – 100 @ $4  ****                     400      - 7% return immediately

If the stock price is above $60 at strike
date, investor receives another $2 ($60-$58)               200      - 3% return

Total return on investment is                                    $600      - 10%

**** The $400 call premium is a capital gain in the year it is received and is not a reduction in the cost base. See my comment to Anonymous in the comment section below for the income tax treatment

If the stock price is below $60 at strike date, the stock will not be called and you will keep the $400 time premium.  However, you have lowered your out of pocket cost of your investment to $5,400 and you still own the stock. Please note that you must hold the stock until the call is exercised or expires.

The downside to using this strategy is that if the stock price rises above $60 you do not participate in any of the upside above $60. Therefore, using a covered call may be more risky for a stock like Research in Motion which can swing dramatically, than for a stock like the Royal Bank, but that would be reflected in the premium you get for selling the call.

In the case of a stock such as Bell Canada that pays dividends, one has to be aware that the  call holders may want to capture the dividend and that has to be factored in.

As often happens in blogging, someone else covers the topic of your blog before you post it. An excellent  detailed step by step summary of the mechanics of writing a covered call are covered in this blog by The Million Dollar Journey.

Please understand that I am in no way recommending a covered call strategy. I am only discussing the concept so you are aware of its existence. The use of a covered call is complex and you should consult with your investment advisor before undertaking such a strategy or if you trade yourself, ensure you grasp the complexities in doing such.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs.