Puts and calls may seem a little bit exotic at first, but their potential to earn you some handsome extra income from stocks you already own may well be worth it.
A strategy for using options to produce extra income is called ‘covered call writing’ or ‘selling covered calls’. Selling covered calls represents an additional way to reap some more income from stocks you already own and possibly are receiving dividends on.
When you trade options, there is a fundamental rule that should never be forgotten. You cannot have an opinion unless you first have an opinion on the underlying stock.
How an option performs is very much—not totally, but very much—related to how the underlying stock performs.
In order for a covered write to be an appropriate strategy, for example, you have to already own the underlying stock. That alone indicates that you are bullish on the stock. If you weren’t, you wouldn’t already own it.
But it’s more than that. You have to be bullish on the share price over the longer term. But you also have to be not nearly as bullish over the near term.
Take a look, for example, at the overall S&P/TSX Composite Index from April 7, 2016, to Oct. 21, 2016. During those roughly seven months the index rose an impressive 12.6 per cent. You decide that, long term, you are still bullish on the index.
But in the interim, you also think it will take a bit of a pause, because of the U.S. election, before resuming its upward trend. You decide to do a covered write on the index as a whole.
It’s all in the timing
That would have been a good call for a while. (We have the benefit of hindsight here, of course.) Because from October 21 to November 4, the index dipped down by nearly three per cent. And it didn’t surpass its October 21 level until about November 19. From there it continued upward on optimism generated by Donald Trump’s victory in the U.S. election.
The above example illustrates another key aspect about options trading: it’s important to be fairly precise about the term to maturity, or ‘tenor’, of the options you’re selling. In the above scenario, selling a two-week call, or a four-week call, would have worked out in your favour.
But a six- or an eight-week call? That would not have worked out in your favour.
The point is this. If you’re selling calls against a stock position or a stock index, it’s important to get the timing right.
If you’re in doubt about how short the short-term is over which you’re not so bullish on the stock or the index, it’s far better to be too short in your forecast than to be too long with it.
Different tenors also available on individual stocks
Besides there being puts and calls available on certain stocks, there are also different terms or ‘tenors’ for those puts and calls at the same time. For example, at one particular point in time, you might have the choice of doing a covered write on a stock by selling a three-month call option, a six-month call option, or even a nine-month call option.
Call options on stocks, called equity calls, don’t tend to be available for longer than nine months, and calls on stock indexes don’t tend to have tenors longer than three months out. There are specific patterns as to what tenors are available; each stock is assigned one, called a cycle.
For example, Loblaw Companies Ltd. (TSX—L) has both call and put options listed on the Montreal Exchange (www.m-x.ca). Right now, you can trade calls expiring on the third Friday of April, of July, and October of this year.
Thus, for Loblaw, you could do a covered write for as long as about five-and-a-half months from now, and perhaps as short as a week or two. And whatever tenors are available for calls, the same tenors are available for the same stock’s put options.
This is an edited version of an article that was originally published for subscribers in the March 17, 2017, issue of Money Reporter. You can profit from the award-winning advice subscribers receive regularly in Money Reporter.
Money Reporter, MPL Communications Inc.
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