As can be seen in the following graph, the price trend for shares in the Canadian National Railway Company (CNR) appears to have faltered. The stochastic oscillator indicator has just fallen below 75, much like it did in June 2019. At that time, the price of CNR stayed in a channel for many weeks. As long as the oscillator remains below 75, we can assume that history may be repeating itself. To take advantage of this situation, an investor who holds shares in CNR could implement a covered call strategy, writing call options to generate additional income on the shares, for long as this situation continues.
Chart 1: Daily price changes in CNR to November 28, 2019 ($122.25)
The investor could sell one call option contract for every 100 shares held. Based on CNR’s price of $122.25, we will evaluate two call options expiring on January 17, 2019, with strikes of $120 and $125.
Table 1: Comparison of profit and loss profiles
Source: Montréal Exchange
The above table compares two profit and loss profiles for a strategy of writing covered calls, based on strikes of $120 and $125.
Call options with a strike of $120 allow the investor to collect a premium of $3.60 per share, or $360 per contract. This in-the-money option, which has an intrinsic value of $2.25 ($122.25 – $120.00) and a time value of $1.35 ($3.60 – $2.25), provides 2.95% protection against a drop in the price of CNR. The maximum profit is $1.35 per share ($120.00 strike – $122.25 stock price + $3.60 premium received), or 1.14% (8.31% annualized), which will be realized if the stock is trading above the $120 strike when the option expires on January 17, 2020. The static profit (i.e. the profit generated if the stock price is stable until expiry) is the same as the maximum profit.
The call options with a strike of $125 allow the investor to collect a premium of $1.10 per share, or $110 per contract. This out-of-the-money call option, which has no intrinsic value and a time value of $1.10, provides 0.90% protection against a drop in the stock’s price. The maximum profit is $3.85 per share ($125.00 strike – $122.25 stock price + $1.10 premium received), or 3.18% (23.20% annualized), which will be realized if the stock is trading above the $125 strike when the option expires on January 17, 2020. The static profit (i.e. the profit generated if the stock price is stable until expiry) is $1.10 per share (the time value of the call options), and represents a return of 0.91% (6.63% annualized).
When choosing the strike, the investor has to make a trade-off between the maximum return and the protection afforded by the options against a drop in the stock price. At-the-money options offer more protection than out-of-the-money options. However, they also block access to gains in value, effectively limiting profits if the stock rallies.
If the stock price falls or remains stable, the investor can take action if the call options sold can be bought back for between 10% and 20% of their initial price. In such a case, it would then be important to analyze whether additional call options should be written as a hedge against risk. If the stock price rises above the strike, the call options will need to be bought back—at either a profit or a loss depending on the situation—to prevent them from being assigned and to avoid being obliged to sell the underlying stocks. Otherwise, the call options will be exercised by the holder, and the investor will be forced to sell the stock at the agreed strike.
Good luck with your trading, and have a good week!
Originally Posted on December 3, 2019 – Writing Covered Call Options to Profit from a Period of Consolidation
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