This website uses cookies to collect usage information in order to offer a better browsing experience. By browsing this site or by clicking on the "ACCEPT COOKIES" button you accept our Cookie Policy.

Writing Covered Call Options following a Period of Consolidation

Option Matters

Contributor:
Option Matters
Visit: Option Matters

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)

Daily price changes in CNR to November 28, 2019 ($122.25)

Source: Tradingview.com

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

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.

Further action

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

The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.

Disclosure: Option Matters

This material is from Bourse de Montréal Inc. and is being posted with its permission. Opinions expressed in this document do not necessarily represent the views of Bourse de Montréal Inc.

This document is made available for general information purposes only. The information provided in this document, including financial and economic data, quotes and any analysis or interpretation thereof, is provided solely for information purposes and shall not be construed in any jurisdiction as providing any advice or recommendation with respect to the purchase or sale of any derivative instrument, underlying security or any other financial instrument or as providing legal, accounting, tax, financial or investment advice. Bourse de Montréal Inc. recommends that you consult your own advisors in accordance with your needs before making decision to take into account your particular investment objectives, financial situation and individual needs.

Although care has been taken in the preparation of this document, Bourse de Montréal Inc. and/or its affiliates do not guarantee the accuracy or completeness of the information contained in this document and reserve the right to amend or review, at any time and without prior notice, the content of this document.

Neither Bourse de Montréal Inc. nor any of its affiliates, directors, officers, employees or agents shall be liable for any damages, losses or costs incurred as a result of any errors or omissions in this document or of the use of or reliance upon any information appearing in this document.

Disclosure: Interactive Brokers

Information posted on IBKR Traders’ Insight that is provided by third-parties and not by Interactive Brokers does NOT constitute a recommendation by Interactive Brokers that you should contract for the services of that third party. Third-party participants who contribute to IBKR Traders’ Insight are independent of Interactive Brokers and Interactive Brokers does not make any representations or warranties concerning the services offered, their past or future performance, or the accuracy of the information provided by the third party. Past performance is no guarantee of future results.

This material is from Option Matters and is being posted with permission from Option Matters. The views expressed in this material are solely those of the author and/or Option Matters and IBKR is not endorsing or recommending any investment or trading discussed in the material. This material is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation to buy, sell or hold such security. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.

Disclosure: Options Trading

Options involve risk and are not suitable for all investors.

Options involve risk and are not suitable for all investors. For more information read the “Characteristics and Risks of Standardized Options”. For a copy, call 312 542-6901.

trading top