Covered call index options
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Covered Calls using Index Options — A Path Less Travelled. Very few however look past their most basic form…. In this post, I outline an alternative approach that despite being rarely used , has solid academic research behind it and offers some surprising advantages.
A covered call, also known as a buy-write, is a relatively simple investment strategy where the basic form involves buying shares and selling call options using the same underlying stock.
The strategy generates income, provides a cushion against a fall in the price of the share, but does however cap the maximum potential gain in that particular period. The investor therefore is effectively exchanging upside for certain income and reduced volatility.
There is little wonder why it has become so popular amongst DIY investors. An investor who chooses to use covered calls faces a number of constraints, two of which I will explain now. Firstly, it is essential that there exists a direct relationship between the share price and the call option.
It is absolutely necessary, that the investor sell options for the same underlying shares as she has previously bought. For example, if she buys BHP shares she must also sell BHP options. A second constraint investors face when looking to implement basic form covered calls is that they are limited to those shares that have options listed by the ASX. At first glance the list looks impressive and stands at around 85 but further examination reveals, that due to poor liquidity, the effective list is closer to In summary, the basic form covered call is created by buying shares and selling the same underlying options from a universe of around 25 stocks.
Anyone who has been involved in the market for any length of time has probably come across the ASX , which is simply a weighted index of the largest shares listed on the exchange. Also called the XJO, the index is used to track the overall trend of the market as it takes into account a weighted movement of each stock. The astute reader may recognise that although the XJO cannot be bought, in theory, if all companies were held an XJO call option could be sold and a covered call would be created.
The stocks would have to be purchased using the same weightings as the XJO and would have to be rebalanced from time to time but in theory it could be done. From a practical standpoint however it would be impossible or at the very least cost prohibitive as most investors do not have the resources to buy stocks, plus the brokerage costs would be horrendous, more than wiping out the benefits of the strategy.
Whilst this is true for the basic form covered call, it does not necessarily hold in general. Or more simply, the price of the call option needs to be highly correlated with the bought asset.
The answer is yes. It is possible to construct a small portfolio of listed companies that have a very high correlation to the index itself, so much so that they could be used as a substitute for the index.
market indexes - Sell covered call on an index option - Personal Finance & Money Stack Exchange
For example this financial year the ASX 20 an index comprised of 20 companies currently has a beta of 1. Whilst a discussion of beta is beyond the scope of this post, a measure of 1. This is illustrated beautifully from the below chart which shows the movement of the two over the last 6 months. Notice how they almost perfectly follow each other. The ASX 20 was simply used as an example and in practice you would construct a suitable portfolio using almost any of the top companies. With some creative thinking we have been able to create a portfolio which contains a manageable number of stocks and has a high correlation to the XJO.
This means we could in essence create a covered call by buying those stocks and selling an XJO Index option.
3 Covered Call ETFs to Pump Up Your Income - December 10, - jyfyyuxy.web.fc2.com
For those of you following closely, we have overcome the original constraints of the basic form covered call ie: Overcoming those first two constraints is great but there are plenty of other reasons to use index options to build a buy-write.
Despite index options being rarely used by investors — at least in Australia — there has been a very substantial study conducted by SIRCA. SIRCA is the regions leading independent financial services research hub and was founded by 25 collaborating universities.
It is highly respected and generates some outstanding research. Of course any returns generated in the past are not necessarily replicable today, they are reassuring to have. Although previously alluded to, one of the fundamental requirements of constructing a covered call or buy-write is to ensure that is there is a strong correlation between the underlying asset at the sold call options. This is paramount and investors must be vigilant in monitoring this as failure to do so results in increased risk.
The Basics Of Covered Calls
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A Good Option: Covered-Call Funds - Barron's
Very few however look past their most basic form… In this post, I outline an alternative approach that despite being rarely used , has solid academic research behind it and offers some surprising advantages. The Basic Form Covered With Individual Options A covered call, also known as a buy-write, is a relatively simple investment strategy where the basic form involves buying shares and selling call options using the same underlying stock.
Why Else Would You Want to Use Index Options Rather Than Individual Options? This means if we are exercised ie: Also because we use a single option rather than one for each stock holding we reduce costs here too. Every dollar saved on transaction costs increases our return.
The high levels of liquidity mean we have plenty choice regarding which strike to select and the spreads tend to be tighter again reducing our costs. SIRCA Research Despite index options being rarely used by investors — at least in Australia — there has been a very substantial study conducted by SIRCA. Did you enjoy this article? We promise never to spam you, and you can always unsubscribe New Trading Platform Bellmont is delighted to announce a new online trading platform will be launching in July alongside our existing Prime platform.
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