Hedge-Lite: Writing Covered Calls

I'm remain net long as I seek to achieve my goal of $50,000 in yearly distributions. However, it really is painful to see the market value of my portfolio take a beating. Seriously painful. One strategy that works in a stable or declining market is writing Covered Calls to effectively create a small and limited hedge of my positions.

Writing a Covered Call means you are selling the right for another entity to Purchase shares that you own at a set Strike Price. This occurs if the share price is above the set Strike Price and works in a stable or declining market because the likelihood of expiry of the Call Option increases as share price decreases below the Strike Price (Out of the Money).

Expiry is the best outcome as it becomes free money in your pocket without further commissions. The Premium also generates a greater buffer for your shares, albeit it can be small one depending on the duration of the Call. The second best outcome would be buying back (Buy to Close) the Call options at a lower price. However, this makes more sense if you believe the market will rebound. The third best outcome might actually be the release of funds locked into the stock, which allows you to go and re-deploy the cash into another investment. An additional boost would be if any dividends are paid out during this time period until expiry of Buying to Close.

What are the hindrances to executing this strategy?

1. Belief that the market will rebound by the time of expiry
• Thinking the market will go back up after you write the Covered Call may cause you to think twice before writing the Covered Call.  This certainly could happen, but the vital piece of this strategy is that the Call is Covered by actual shares you own.
2. Commissions
• Depending on your brokerage the cost of buying/selling an Option is higher than buying actual shares. Also, you may need to consider the additional and much higher commission of Assignment, or when the stock is above the Call's Strike Price and hence must be sold.
3. Matching a good expiry date with a worthwhile Premium
• Does the Premium compensate you enough for the risk of having your shares sold and the time spent to wait for expiry?
• Does the Premium accommodate commission costs if you were to either Buy to Close or get Assigned?
4. Seller's Remorse
• You write a Covered Call then the share price goes up, which makes it more likely you'll be assigned and the actual price of the Call will go down.
5. Limited inventory of a stock
• A higher number of shares will allow you to extract more Premiums and to spread out the Commission costs, which increases the cash potential.

Example:

BNS

Current Price $52.92

Average Cost: $56.3952

Covered Call: BNS 2016APR15 56.00

Premium: $1.0278 (after commissions)

This means when April 25, 2016 rolls around and the share price does not reach $56.00 then I will pocket the $1.0278. In addition, there is a limited hedging aspect. I would consider the $1.0278 as a buffer for potential losses. In effect I am protected as if my shares' average cost is $56.3952-$1.0278=$55.3674.  When the Call options expire it will not impact the actual average cost; merely the cash that is now mine.

Looking at Buying to Close, the last indicated trade price was $0.87. This would mean $1.0278-$0.87=$0.1578. A much smaller buffer than if waiting for expiry.

As mentioned above, in this case there is a benefit with receiving an additional dividend before expiry date. BNS has an upcoming ex-dividend date of April 1; for an as of yet un-announced dividend of $0.70. This will provide an additional buffer the any downside of the share price.

The question is what if you own; in my case approximately 700 shares? Would I write a full 7 contracts or less? That is not as easily answered and depends on your needs. I wrote a post about Building Inventory For Covered Calls as a guide for myself of what portion of my share holdings I would be willing to part with via Covered Calls.