The month of august was not kind to investors. September did not start so well, either, leaving investors to ponder whether equities markets are in correction mode or commencing a bear market cycle. This is a common theme, reflecting the binary relationship between bulls and bears.
Options traders, on the other hand, have flexibility. They can hedge long positions, engage in limited-risk short positions or trade on market volatility. These are the advantages of trading in a market that measures risk.
Virtually all markets become more volatile during sell-offs. Fear means higher prices for options, as traders pay up for protection. Think of this scenario as paying more for insurance when perceived risks begin to rise.
The market prices options in terms of implied volatility – and this risk factor has increased dramatically since midsummer. For example, at the time of writing in September, index options were trading at a 23% implied volatility – up from 15% implied volatility at the end of July.
As options prices surge, covered option strategies become more attractive. The most common strategy is “covered call writing”; in this strategy, you buy the underlying stock and sell a covered call with a strike price that is slightly above the current market price for the stock.
Attractive environment
Let’s take the example of Facebook Inc. (NYSE: FB; recent price: US$89.50). Facebook’s stock price is down by about 10% from recent highs, which has been reflected in the value of Facebook options. At the time of writing, the Facebook March 95 calls were trading at US$7.25.
In this example, your client would buy Facebook shares and sell the March 95 calls. At this point, three things occur: 1) US$7.25 per share immediately provides cash flow to the portfolio; 2) the client’s cost base has been reduced by the premium received; and, 3) a price (US$95 strike price) and timeline (March 2016 expiration) has been set when the position is established.
Enhanced return metrics
What makes the current environment attractive is the enhanced return metrics within the covered call strategy. In the Facebook example, only one of three outcomes will occur between now and the March expiration: the shares will rise, fall or stay the same.
If the shares rise above the strike price at the March expiration, the short calls will be exercised and your client will deliver his or her Facebook shares to the call buyer and receive US$95 per share. The six-month return in this scenario is 14.2%.
If the shares remain the same price, or even rise slightly but are not above the strike price at the March expiration, your client retains the shares and could potentially sell another six-month call option against the position.
If the stock price remains the same, the covered call strategy earns 8.1% over six months. This is well above the zero return that a long holder of the shares would receive under a static scenario.
Facebook shares could drop in price between now and the March expiration. In this scenario, the covered call strategy provides partial downside protection. The sale of the call option reduces the cost of your Facebook shares to US$82.25 (initial purchase of US$89.50 less the US$7.25 premium = US$82.25 cost base).
Growth at a good price
By executing the Facebook covered call strategy, your client is in a better position in two of the three aforementioned scenarios. In fact, the only scenario in which the covered call writer underperforms is if Facebook stock rallies substantially between now and the call’s March expiration date.
In that case, your client forfeits any gain above the strike price of the short call. But your client still earns the maximum return as set out when the position was established. Yet, Facebook has a solid earnings trajectory and increasing user engagement. The company is the ultimate example of buying “growth at a reasonable price” (a.k.a. GARP).
The same strategy also works well in other sectors. Specifically, sectors such as energy, which has experienced above-average volatility. With that in mind, covered calls on companies such as Suncor (TSX: SU; recent price: $34.30) and Canadian Natural Resources (TSX: CNQ; $26.55) look interesting.
With Suncor, your client could purchase the shares and sell the March 35 calls at $2.45. The six-month return, if exercised, is 9.48%; the return if unchanged is $7.43; and the downside break-even point is $31.75.
With CNQ, your client could buy the shares and sell the February 27 calls at $2.65. The five-month return, if exercised, is 11.68%; the five month return, if unchanged, is 9.98%; and the downside break-even point is $23.90.
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