The sharemarket offers investors various ways of making money. A popular approach is to buy shares with the expectation of a price increase that will deliver a capital profit.
If you already own shares, many will pay dividends that may be enhanced by tax credits under the dividend imputation system. A third source of income for more sophisticated investors who also own shares is via exchange traded options.
Exchange traded options are investments that are offered in parcels of generally 1000 shares over the most prominent companies listed on the stock exchange like the major miners and the big banks. Investors who own such parcels can use them to make extra income through an options strategy described as a covered call.
A covered call is a strategy where investors offer to sell options against the shares they own for the premium income an option buyer is prepared to pay. What attracts the option buyer is the right to acquire the shares for a predetermined price over a certain period of time – say anytime over the next three months. The terms of the transaction are set down in the options contract.
While the premium income that gives the option buyer the right to acquire the share may often be only a modest amount, say 1 to 3 per cent of the contract value, as far as the option seller is concerned it’s a low risk way to earn some extra income.
Most option sellers embark on the strategy with the expectation the share price movement for the period they are willing to sell their shares under an option arrangement will be either neutral or only mildly bullish. This implies a low risk of the options being exercised.
There are good reasons for this. The last thing long term share owners want when offering covered calls is to have the options exercised and their shares called away. Such an event can have undesirable ramifications like capital gains tax implications if the shares are profitable. And if the shares happen to be coming up for a dividend payment, a buyer deciding to exercise the options before the ex-dividend date will cost the investor the dividend plus any franking credit entitlements.
For these reasons options sellers will often set the prices for which they are willing to sell their shares at between 5 to 10 per cent above the current market price.
According to James Staltari of Westpac Online Investing the start of 2011 has seen an increase in the popularity of the covered call strategy. Driving this has been investors observing that many shares have begun the year trading in defined ranges with low expectations in the immediate future they will rise through the levels that could see them being exercised.
As an example, investors who owned parcels of 1000 BHP Billiton shares trading at around $44.50 each late last week were setting levels of $48 at which they would be willing to have their shares called away over a three month period up to the end of March.
In exchange for granting option buyers this right – at a price that was 8 per cent above the market price – they were collecting premium income of around 48c per option or $480 for 1000 options. This income matched the most recent dividend paid by BHP.
Staltari said investors who offer their shares under a covered call strategy need to be aware that a sharp increase in the share price could see option buyers acquiring the shares, which they will do if it is worth their while. Of course any buyer will have to pay the price set under the contract, for example $48 per share plus the premium they paid to acquire the options.
Source: SMH
Posted on May 27th, 2011 
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