Covered Calls. Benefits & Tradeoffs

Transcription

1 Covered Calls Enhance ETFs with Options Strategies January 26, 2016 Joe Burgoyne, OIC Benefits & Tradeoffs Joe Burgoyne Director, Options Industry Council

2 2 The Options Industry Council Options involve risks and are not suitable for everyone. Prior to buying or selling options, an investor must receive a copy of Characteristics and Risks of Standardized Options. Individuals should not enter into options transactions until they have read and understood the risk disclosure document, Characteristics and Risks of Standardized Options, available by visiting Copies may also be obtained by contacting your broker or The Options Industry Council at One North Wacker Drive, Chicago, IL In order to simplify the computations, commissions, fees, margin interest and taxes have not been included in the examples used in these materials. These costs will impact the outcome of all stock and options transactions and must be considered prior to entering into any transactions. Investors should consult their tax advisor about any potential tax consequences. Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities. Past performance is not a guarantee of future results. Copyright 2015 The Options Industry Council. All rights reserved.

3 3 Who We Are About OIC The Options Industry Council (OIC) is an industry cooperative funded by OCC, the world s largest equity derivatives clearing organization and sole central clearinghouse for U.S. listed options, and the U.S. options exchanges. OIC s mission is to provide free and unbiased education to investors and financial advisors about the benefits and risks of exchange-traded equity options. Managed by OCC, OIC delivers its education through the Options Education Program, a structured platform offering live seminars, self-directed online courses, mobile tools, podcasts, webinars and live help. OIC s resources can be accessed online at or via mobile app for ios. About OCC OCC is the world s largest equity derivatives clearing organization and the foundation for secure markets. Founded in 1973, OCC operates under the jurisdiction of both the U.S. Securities and Exchange Commission (SEC) as a Registered Clearing Agency and the U.S. Commodity Futures Trading Commission (CFTC) as a Derivatives Clearing Organization. OCC now provides central counterparty (CCP) clearing and settlement services to 16 exchanges and trading platforms for options, financial futures, security futures and securities lending transactions. More information about OCC is available at

4 4 U.S. Listed Options Exchanges

5 5 Annual Options Volume, Cleared Contracts, Billions Futures Non-Equity Equity

6 6 Options on ETF Annual Volume ,000 1,800 Millions of Contracts 1,600 1,400 1,200 1,

7 7 Slide Presentation Options on ETFs Buy ETF Call Buy ETF Put Buy ETF Protective Put Covered ETF Call ETF Collar Conclusion

8 Options on ETFs

9 9 What are Options on ETFs? Options on ETFs are contracts that give the holder the right and the writer an obligation to buy or sell 100 underlying ETF shares at the strike (exercise) price per share at any time before the expiration date Considered equity options Available on a variety of ETFs listed and traded on U.S. options exchanges LEAPS may be available

10 10 ETF vs. Equity Options Contract Terms Underlying ETF Options ETF Equity Options Stock Settlement Unit of trade Expiration Last trade Exercise style Physical 100 Shares third Friday of month (standard options) Expiration Friday unless holiday American Trading hours May vary 8:30 am to 3:00 pm Central Multiplier Premium point = $100

11 11 ETF Pricing Factors Same as Equity Options Factors underlying ETF price strike price volatility of ETF shares time until expiration interest rate dividends Implied volatility assumption at which option currently priced underlying ETF volatility expected by marketplace generally lower for index than individual components Volatility and time decay affect only time value

12 12 Option Pricing Calculator Option pricing calculator accessible: numerous Web sites Example option pricing calculator For illustrative purposes only

13 13 ETF Options vs. Index Options ETF Options Physical settlement American-style Underlying may be bought/sold Smaller strike increments Index Options Cash settlement Most are European-style No underlying to buy/sell Greater strike increments LEAPS contracts may be available for both

14 14 Ways to Use ETF Options Capitalize on market opinion with long options potential for leveraged profits predefined, limited loss Short-term plays on over- or under-performance broad market, sectors or asset classes With appropriate ETF choice, adjust with one trade diversification, asset allocation, correlation Hedge portfolio risk or with objective to boost returns

15 15 Optionable ETF Products Stocks Bonds Commodities Volatility International Stocks Currencies Fixed Income And more

16 16 Commodity ETF s ETF options can be used to invest in commodity markets without having to participate in futures markets Commodity ETFs have an advantage over CFTC regulated commodity options due to risk offset in that you can keep them in a securities account rather than a separate futures account Sector ETF s can be used to help diversify a portfolio and also provide volatility trading and risk management opportunities

17 17 Why ETF Options? Why Bother? Wide variety of strategies are available Long Call Short Call Long Put Short Put Long Straddle Short Straddle Long Strangle Short Strangle Long Call Spread Long Put Spread Short Call Spread Short Put Spread Ratio Call Spread Ratio Put Spread Call Volatility Spread Put Volatility Spread Long Split- Strike Synthetic Collar ETF options give you options!

18 Buy ETF Call

19 19 Bullish Investor Investor bullish on an industry sector unsure of specific stock to purchase wants diversified long position sector index tracked by ETF XYZ Decision: buy 1 XYZ call Possible motivations speculation for leveraged upside profits purchase underlying XYZ shares

20 20 Bullish Investor Choice of strike price depends on motivation In-the-money more conservative plan to exercise and buy ETF shares At or Out-of-the-money more speculative objective: sell call for profit More out-of-the-money the more speculative set expectations accordingly

21 21 Buy Call Example Opinion: bullish on XYZ over next two months XYZ currently at $75.00 Action buy 1 XYZ call at $2.90 call in-the-money total cost: $2.90 x 100 = $ Available 2-month calls XYZ call XYZ call XYZ call Compare to XYZ purchase buy 100 XYZ shares at $75.00 = $7, total $2.90 $2.40 $1.90 Not including commissions

22 22 Buy 1 XYZ Call at $ Long XYZ at $75.00 Break-even at Expiration: Strike Price + Premium Paid $ $2.90 = $ Maximum Loss: $2.90 Premium Paid $ Total 5 BEP $76.90 Profit Potential: Unlimited Not including commissions

23 23 Buy 1 XYZ Call at $2.90 XYZ Price at Expiration Long Call Value at Expiration Long Call Initial Cost Total Profit/(Loss) $80.00 $78.00 $6.00 $4.00 ($2.90) ($2.90) $3.10 $1.10 $76.90 $2.90 ($2.90) 0 $ ($2.90) ($2.90) $ ($2.90) ($2.90) Not including commissions

24 24 Buy 1 XYZ Call at $2.90 vs. Buy 100 XYZ at $75.00 XYZ Price at Expiration Long Call Profit/(Loss) Long Call % Profit/(Loss) Long XYZ Profit(Loss) Per Share Long XYZ % Profit/(Loss) $85.00 $80.00 $8.10 $ % 107% $10.00 $ % 7% $75.00 ($1.90) (66%) 0 0 $70.00 ($2.90) (100%) ($5.00) (7%) $65.00 ($2.90) (100%) ($10.00) (13%) Not including commissions

25 25 Buy 1 XYZ Call at $2.90 Exercise at expiration buy 100 XYZ at $74.00 per share Net cost paid for XYZ shares $74.00 strike + $2.90 premium paid = $76.90 per share $7, total Risk before exercise premium paid always at risk for all long ETF options Risk after exercise downside on 100 long shares = $7, Not including commissions

26 Buy ETF Put

27 27 Bearish Investor Investor bearish on broad market uncomfortable with risk of any short stock positions wants diversified short position with limited risk broad market index tracked by ETF XYZ Decision: buy 1 XYZ put Motivation speculation for leveraged downside profits

28 28 Bearish Investor Choice of strike price depends on motivation In-the-money more conservative has intrinsic value less vulnerable to decay At or Out-of-the-money more speculative all time value total cost vulnerable to decay More out-of-the-money, the more speculative need greater move to downside for profit set expectations accordingly

29 29 Buy Put Example Opinion: bearish on XYZ over next two months XYZ currently at $75.00 Action buy 1 XYZ put at $2.00 put out-of-the-money Total cost: $2.00 x 100 = $ Available 2-month puts XYZ put XYZ put XYZ put $2.00 $2.45 $3.00 Not including commissions

30 30 Buy 1 XYZ Put at $ BEP $72.00 Break-even at Expiration: Strike Price Premium Paid $74.00 $2.00 = $72.00 Maximum Loss: $2.00 Premium Paid $ Total Profit Potential: Substantial Not including commissions

31 31 Buy 1 XYZ Put at $2.00 XYZ Price at Expiration $76.00 $ ($2.00) ($2.00) ($2.00) ($2.00) $72.00 $2.00 ($2.00) 0 $70.00 $68.00 Long Put Value at Expiration $4.00 $6.00 Long Put Initial Cost ($2.00) ($2.00) Total Profit/(Loss) $2.00 $4.00 Not including commissions

32 32 Buy 1 XYZ Put at $2.00 Exercise at expiration sell 100 XYZ at $74.00 per share Net received for XYZ shares $74.00 strike $2.00 premium paid = $72.00 per share $7, total Risk before exercise premium paid always at risk for all long ETF options Risk after exercise short 100 XYZ shares unlimited upside risk Not including commissions

33 Buy ETF Protective Put

34 34 Defensive Investor Investor long ETF XYZ concerned about downside protection wanted Decision: buy XYZ protective put 1 put for each 100 XYZ shares owned Each protective put grants right to sell 100 shares at strike price until expiration as long as put is owned

35 35 Defensive Investor Upside profit potential on XYZ shares unlimited less cost of put Downside loss on XYZ shares limited may be sold at strike price upon exercise Choice of strike price depends on protection needed

36 36 Protective Put Example Opinion: bullish on XYZ defensive over next two months Long 100 XYZ at $76.00 XYZ currently at $75.00 Action buy 1 XYZ put at $1.50 put is out-of-the-money Total cost: $1.50 x 100 = $ Available 2-month puts XYZ put $1.20 XYZ put $1.50 XYZ put $1.95 Not including commissions

37 37 Buy 100 XYZ at $76.00 Buy 1 XYZ Put at $ Break-even at Expiration: ETF Price Paid + Put Premium Paid $ $1.50 = $77.50 Long XYZ at $ BEP $77.50 Maximum Loss: ETF Price Paid Break-even for Put $76.00 ($73.00 $1.50) = $4.50 $ total Profit Potential: Unlimited Not including commissions

38 38 Buy 100 XYZ at $76.00 Buy 1 XYZ Put at $1.50 XYZ Price at Expiration $85.00 $80.00 Long Put Value at Expiration ($1.50) ($1.50) Long XYZ Profit/(Loss) $9.00 $4.00 Total Profit/(Loss) $7.50 $2.50 $77.50 ($1.50) $ $75.00 $70.00 $65.00 ($1.50) $1.50 $6.50 ($1.00) ($6.00) ($11.00) ($2.50) ($4.50) ($4.50) Not including commissions

39 39 Buy 100 XYZ at $76.00 Buy 1 XYZ Put at $1.50 Exercise at expiration sell 100 XYZ at $73.00 per share Net received for XYZ shares $73.00 strike $1.50 premium paid = $71.50 per share $7, total Risk before exercise limited Not including commissions

40 Covered ETF Call

41 41 Investor Seeking Income Investor neutral to moderately bullish on ETF XYZ expects small price range over next few months Decision: write covered call buy 100 XYZ shares write 1 XYZ call

42 42 Investor Seeking Income Primary Motivation increase returns call premium received and kept generates additional income (over any dividends) trade-off is upside on shares limited by short call Call premium s limited downside benefit lowers XYZ shares break-even point reduces cost basis only by premium amount received

43 43 Covered ETF Calls Call writer s obligation sell XYZ shares if assigned at any time before expiration Long XYZ shares collateralize short call obligation if assigned shares sold already owned Risk is in the long XYZ shares Long ETF Covered ETF Call

44 44 Covered ETF Calls Write in-the-money call defensive and more conservative more premium received more downside protection less upside profit potential Write out-of-the-money call aggressive and less conservative less premium received less downside protection more upside profit potential

45 45 Covered ETF Calls Strike price selection assess your tolerance for risk balance upside profit potential vs. limited protection pick strike accordingly Generally considered conservative strategy reduces (not limits) downside risk Outperforms long XYZ shares if price declines, unchanged or rises slightly

46 46 Covered ETF Calls Maximum profit potential if assigned limited strike price share price paid + call premium received Break-even point share price paid call premium received Downside loss potential substantial risk is with XYZ shares entire share cost less call premium received at risk

47 47 Covered ETF Call Example Opinion: neutral to moderately bullish on XYZ XYZ currently at $75.00 Expect XYZ to trade between $73.00 and $77.00 for next 90 days Action buy 100 XYZ at $75.00 sell 1 XYZ call at $2.10 XYZ call XYZ call XYZ call XYZ call XYZ call A $0.50 dividend is expected before expiration Available 3-month calls $3.95 $3.40 $2.90 $2.45 $2.10 Not including commissions

48 48 Covered ETF Call Example Profit and Loss at Expiration Break-even at Expiration: BEP $72.90 ETF Price Premium Received $75.00 $2.10 = $ Maximum Loss: Substantial Maximum Profit if Assigned: (Strike Price ETF Price Paid) + Call Premium Received ($77.00 $75.00) + $2.10 = $4.10 $ total Not including commissions

49 49 Covered ETF Call Example Profit and Loss at Expiration Buy 100 shares XYZ at $75.00 Sell 1 XYZ call at $2.10 XYZ Price at Expiration $85.00 $80.00 $10.00 $5.00 ($5.90) ($0.90) $ $2.10 $2.10 $70.00 $65.00 Long XYZ Profit/(Loss) ($5.00) ($10.00) Short Call Profit/(Loss) $2.10 $2.10 Net Profit/(Loss) $4.10 $4.10 ($2.90) ($7.90) Not including commissions

50 50 Early Assignment for Dividend Early assignment possible before dividend on or just before ex-dividend date You might expect early assignment when expiration is relatively near dividend greater than call s time value XYZ will pay $0.50 dividend ex-dividend date four days before expiration day before ex-date XYZ is at $ call is at $1.60 time value is $0.10 expect assignment

51 Return Calculations

52 52 Static Return Worksheet: Stock Unchanged Call price less commissions Plus dividends + Equals income = Divided by (ETF price plus commissions) Equals % income = Times 365/90 (days to expiration) x Equals annualized static return = $2.10 $0.50 $2.60 $ % %

53 53 If-Called Return Worksheet: Stock though the Strike Call price less commissions Plus dividends + Plus profit from ETF sale ($77.00 $75.00) + Equals income = Divided by (ETF price plus commissions) Equals % income + Times 365/90 (days to expiration) x Equals annualized static return = $2.10 $0.50 $2.00 $4.60 $ % %

54 54 Covered Call Nervous About Downside? In the previous example an investor wrote a covered ETF call Position long 100 XYZ shares at $75.00 short 1 XYZ call at $2.10 Time passes XYZ increases in price a bit investor has downside worries - doesn t want to sell shares buy protective put convert to a collar

55 ETF Collar

56 56 What is an ETF Collar? Collar long 100 underlying ETF shares long 1 put short 1 call Ratio always 100 shares : 1 call : 1 put Call and put generally same expiration month Call strike price higher than put strike price

57 57 Collar: Two Strategies in One A collar can be considered two strategies in one the 100 ETF shares play a part in both On the downside a protective put out-of-the-money put is purchased right to sell shares at strike price until expiration On the upside a covered call out-of-the-money call is sold upside profit potential limited by short call

58 58 Why Use a Collar? ETF buyer with unrealized gains wants downside protection long put some upside participation limited by short call Key benefits put cost fully or partially paid by call premium received objectives met whether share price up or down receive any dividend if not assigned on short call

59 59 Before You Use a Collar Downside protection needed? select appropriate put strike price consider time frame Upside participation on ETF? select appropriate call strike price be happy with share sale price if assigned Balance two factors: put premium paid and protection provided risk call premium received and upside potential reward

60 60 What Does All This Cost? Net Debit Net Credit Zero Cost Put cost more than call premium received Call premium received more than cost of put Call premium received same as put premium paid Buy put $3.00 Sell call + $2.00 Net debit $1.00 Sell call + $4.00 Buy put $1.00 Net credit + $3.00 Sell call + $4.00 Buy put $4.00 Zero Cost $0 Not including commissions

61 61 ETF Collar Example Covered call buy 100 XYZ shares at $76.50 sell 1 XYZ call at $2.10 Convert to collar buy 1 XYZ put at $1.65 Position long 100 XYZ shares currently at $76.50 sell 1 XYZ call + $2.10 buy 1 XYZ put $1.65 Net credit = + $0.45 Not including commissions

62 Conclusion

63 63 Conclusion Among the benefits ETF shares offer diversification and allocation with a single transaction trade like stock on an exchange lower management costs and certain tax advantages vs. mutual funds ETF benefits available to option investors ETF options are considered equity options same pricing factors similar contract terms American-style and physical delivery unlike index options

64 64 Conclusion ETF options offer flexibility of equity options wide range of strategies available Why use ETF options? bullish or bearish speculation buy or sell underlying ETF shares generating additional income managing portfolio risk

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