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Let’s take a look at how leverage can be used in a specific strategy -- covered call writing -- to virtually change the way the strategy behaves.
Most traders would agree that covered call writing is a conservative strategy. That may or may not be the case as we will see. In fact, covered call writing gets its “conservative” label from brokerage firms and exchanges, who have espoused its use in a low-risk manner.
Covered call writing has less risk than owning stock because the option premium received -- no matter how small -- reduces downside risk as compared to stock ownership. For most people, that fact alone is enough to earn the “conservative” tag.
However, in any option strategy, we can use the fact that equivalent positions can be constructed. Some of those strategies -- while still having the same profit and loss potential in dollars as a covered call write -- involve the use of leverage. That leverage can be quite large as we shall see.
In the examples in this article, we will make the assumption that one is creating a new covered call position (or its equivalent) -- not writing calls against stock already owned.
Covered Call Writing Using Cash
The most conservative approach for covered call writers is to buy stock for cash (i.e., to fully pay for it) and to sell calls against it. So that we might have some comparisons among different approaches, let’s go through the motions of calculating the returns of a sample covered call write. For those not familiar with the strategy, this might be useful as an educational exercise as well.
Example: Suppose XYZ is trading at 43, and we buy 100 shares and sell the March 45 call -- expiring in exactly six months -- for 3 points. We will ignore commissions in this example. Furthermore, assume that there will be no dividend payments during the life of this covered call write.
Our pertinent returns are as follows:
Investment Required: $4,000
Profit If Exercised: $500
Raw Return If Exercised: 500 / 4,000 = 12.5%
Annualized Return If Exercised: 25% (six-month holding period)
Profit If Unchanged: $300
Raw Return If Unchanged: 300 / 4,000 = 7.5%
Annualized Return If Unchanged: 15.0%
Covered Call Writing on Margin
The simplest way to leverage a covered call write is to buy the stock on margin. The margin rules for covered call writing are quite favorable to the writer. The broker will lend you the allowable stock margin and then the proceeds from the call write are applied, thereby reducing the amount of investment that you, as the investor, must make.
The broker will lend you 50% of the striking price or of the stock price, whichever is lower. This requirement keeps you from writing deeply in-the-money calls without having to put up any money at all. Nevertheless, one can increase his or her leverage quite a bit just by simple covered call writing.
Let’s look at the same example -- as in the last example, a covered call write of the March 45 calls, trading at 3, with the underlying XYZ stock selling at 43:
Example: Buy stock at 43, on margin, and sell the March 45 call (which has 6 months remaining until expiration) at 3. Assume no commission expense and no dividends, but assume a margin interest rate of 10%. That is, the broker will lend you money, but he or she will charge interest on the loan at the rate of 10% annually (or 5% for this 6-month holding period).
Broker’s
Loan: 50% x 43 (minimum of 43, the stock price, and
45, the strike) = $2,150
Margin Interest to Be Paid for 6 Months: 10% x $2,150
x 0.5 years = $107.50
Your Investment Required: 50% x 43 less the premium
=
$2,150 - $300 = $1850
Profit If Exercised: $500 - interest = $500 - $107.5
= $392.50
Raw Return If Exercised: 392.50 / 1,850 = 21.2%
Annualized Return If Exercised: 42.4% (six-month holding
period)
Profit If Unchanged: $300 - interest = $192.50
Raw Return If Unchanged: 192.50/1850 = 10.4%
Annualized Return If Unchanged: 20.8%
Using an Equivalent Strategy
With options, you often have more than one way to construct a position and still keep the dollars of profit and loss essentially the same. When you do that, the two positions are said to be equivalent. In the case of covered call writing, the equivalent position is really quite simple: It is the sale of a naked put.
Both a covered call write and the sale of a naked put have a profit graph with the same shape -- a limited profit potential above the strike and large downside risk. When two strategies produce a profit graph with the same shape, they are said to be equivalent. Their investments and, hence, return on investment may be quite different, but their profit and loss potential are the same.
It should not come as news to the covered call writer that the sale of naked puts is an equivalent strategy. In fact, many call writers have forsaken the simple covered call writing strategy to become naked put writers because the returns are larger -- through leverage. But, as in all leveraged investments, the risk is increased (in percentage terms) as well.
Let’s return to the same example, with a few simplifying assumptions.
Example: Assume the following prices exist:
XYZ:
43
March 45 Call: 3
March 45 Put: 4.15
Before calculating returns, you must first quantify the investment that would be required. The exchange minimum margin requirements for writing a naked put are as follows:
Margin: 30% of stock price less any out-of-the-money amount plus the option premium with the stipulation that the requirement is at least 10% of the stock price. So, the initial margin requirement for this March 45 put write would be: 30% x 43 + 415 = $1705 (no allowance for out-of-the-money because the put is initially in the money to begin with)
In other words, the investment changes as the stock price changes. This is what often makes it difficult to compare naked option writing with other strategies.
One way that experienced traders often approach this problem of defining the investment is to calculate the expected investment based on the volatility of the stock price. That is, we can calculate the probability of being at a certain stock price, and we know the naked put margin requirement if the stock is there, so, if we multiply those two -- for each stock price -- and sum over the entire spectrum of possible stock prices, we can calculate the expected investment. Of course, that assumes one would not make adjustments prior to expiration -- an unrealistic assumption for real-life trading of naked put options.
So, there is some contention over just how much leverage a naked put writer acquires -- in comparison to the “normal” covered call writer. No matter how it’s computed, leverage factors of approximately 2-to-1 can easily apply -- especially if we account for the fact that margin requirements can vary with the stock price.
In any case, it should always be remembered that the covered-writer-turned-naked-put-writer can always reduce the leverage by allocating a larger investment amount to the strategy -- say, the margin where he or she plans to take defensive action. In the previous example, if one were to figure on taking defensive action at a price of 40, he or she would allow margin of at least $1,700 (30 of 40%, plus the 5 points that the option would be in-the-money).
Infinite Leverage in a Covered Call Write
Ironically, due to the way that margin requirements are computed, it is sometimes possible to construct a covered call write on margin that has infinite leverage! Consider the following example:
Example:
XYZ: 28
Jan (‘08) LEAPS 30 call: 15
You won’t often find a pricing structure like that, but such structures do occasionally exist. In this example, the implied volatility of the Jan LEAPS call would be 94% -- high but not unheard of. The initial margin required for a covered call write of the Jan 30 LEAPS would be:
| Stock margin (50% of 28): |
$1,400 |
| Less Option Premium: |
-
1,500 |
| Margin Required: |
$ - 100! |
In other words, you do not have to put up any of your own money to do this trade. That is infinite leverage. Before you rush to look for these situations, recognize that leverage works both ways. If this stock were to drop below 13 (the breakeven point) before January 2008, expiration, you would have a loss -- and a negative infinite rate of return. Put simply, the simple covered call writing strategy can be tailored -- via leverage -- to be capable of generating higher risk and reward. Thus, even less conservative investors can use this strategy to their advantage. Leverage is neither good nor bad; it just is. One should be aware of leverage, noting if it is available in the strategy he or she is pursuing. But, the options trader should also understand that leverage can be reduced with the infusion of more capital (investment) into a position.
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