Writing Covered Call Options Cover is Subject to Change

Transcription

1 Writing Covered Call Options Cover is Subject to Change Options may not be suitable for particular investors. Before engaging in the purchase or sale of options, potential clients should understand the nature and extent of their rights and obligations and be aware of the risks involved, including, without limitation, the risks pertaining to the business and financial condition of the issuer of the underlying security/instrument. Options investing, like other forms of investing, involves tax considerations, transaction costs and margin requirements that can significantly affect clients potential profits and losses. The transaction costs of options investing consist primarily of commissions (which are imposed in opening, closing, exercise and assignment transactions) but may also include margin and interest costs in particular transactions. Transaction costs are especially significant in options strategies calling for multiple purchases and sales of options, such as multiple leg strategies, including spreads, straddles and collars. If a client is considering engaging in options trading as part of their investment plan, the Financial Advisor or Private Wealth Advisor is required to provide the client with the "Characteristics and Risks of Standardized Options" (ODD) booklet published by the Options Clearing Corporation. Clients should not enter into options transactions until they have read and understood the ODD Disclosure Document, as options are not suitable for everyone, and discussed transaction costs with the Financial Advisor or Private Wealth Advisor. A copy of the ODD is also available online at: Supporting documentation for any claims (including any claims made on behalf of options programs or the options expertise of sales persons), comparisons, recommendations, statistics, or other technical data, will be supplied upon request.

2 Writing Covered Call Options What Is an Option? Options Basics Covered Call Options Strategies Why Covered Call Options? How to Use Covered Call Options Factors Influencing Call Option Pricing Covered Call Options Profit and Loss Chart Covered Call Options Investment Considerations Additional Information Key Risks and Considerations of Writing Covered Call Options Covered Call Options Disclosure and Risks Important Information and Qualifications 2 CAPITAL MARKETS

3 What is an Option? An option contract is an agreement between two investors to buy and sell an underlying asset a stock, bond, index, foreign currency or interest rate at a specific price on or before a certain date. Like a listed stock or bond, an option is a security and trades on an exchange. However, it is also a derivative, which means that its value is derived from an underlying asset. OPTIONS CONTRACT TYPES A call gives the right, but not the obligation, to buy an underlying asset at a specified price A put gives the right, but not the obligation, to sell an underlying asset at a specified price Each options contract generally represents 100 shares of stock 3 CAPITAL MARKETS

4 Option Basics EXERCISING AN OPTION The option buyer will choose to exercise a contract when it is in the money (the asset value is greater than what the buyer would pay), or allow the contract to expire unexercised when it is out of the money (the asset value is less than the buyer would pay) The option writer always wants a contract to expire out of the money, which means no underlying assets change hands. In this case, the seller profits by keeping the premium, which is the amount earned from selling the contract Either way, the option buyer has the right, but not the obligation, to decide whether to exercise the option EXPIRATION Option contracts generally expire on the third Friday of the expiration month. If the third Friday falls on an exchange holiday, the expiration date will move to the Thursday preceding the third Friday. A special contract type, a long-term equity anticipation security (LEAPS), has a lifespan of 39 months 4 CAPITAL MARKETS

5 Covered Call Option Strategies A covered call options strategy involves selling ( writing ) options on common stock and receiving a premium (income). The option is covered because there are no additional collateral requirements as long as the investor can deliver the underlying shares of stock during the life of the call option. Covered Call Option Strategies Buy-write Simultaneous purchase of shares of stock and selling call options on the purchased shares Overwrite Selling call options (wholly or partially) against shares of stock that are already owned by the investor Examples: Investor buys 100 shares of XYZ stock (at $40.00 per share, gross) and simultaneously sells 1 XYZ April 45 call option (buy-write) Investor already owns 100 shares of XYZ stock (and paid $39.00 per share, gross) and sells 1 XYZ April 45 call option (overwrite) 5 CAPITAL MARKETS

6 Why Covered Call Options? Generate income Investor receive a premium (income) when selling call options The investor continues to receive dividends (if any) on the underlying shares Reduce the risk of a share price decline Premium partially offsets a loss resulting from a declining share price Option premium is typically a small percentage of the underlying stock s value Lock in a sale price for the underlying shares of stock Investors can select a call option strike price that reflects their performance expectations for the underlying stock 6 CAPITAL MARKETS

7 How to Use Covered Call Options Assume the following (commissions are NOT accounted for in this illustration): Stock Assumptions: An investor owns 100 shares of XYZ stock XYZ stock is currently trading at $51.00 per share ($5,100) XYZ stock does not pay a dividend Investor is willing to sell the XYZ stock at $55.00 per share ($5,500) Call Options Assumptions: Investor believes XYZ stock will appreciate to $55.00 (but not significantly above) in six months The investor is looking to generate income on the XYZ shares Based on this view, the investor sells 1 XYZ call option that expires about six months from now Gross call option premium is $150 per contract. 7 CAPITAL MARKETS

8 How to Use Covered Call Options (continued) During the life of the call option, the option writer can: 1. Take no action: The value of the call option may change over time based on market fluctuations 2. Buy back the call option: If the investor s view of the XYZ shares changes or if he/she wants to eliminate the possibility of delivering the XYZ shares, the investor could buy back the call option to close out the position. If the call option is bought back, the investor will continue to hold the XYZ shares. 3. Be assigned: Gain scenario: Investor buys back the call option for LESS than he/she received when the call was sold Loss scenario: Investor buys back the call option for MORE than he/she received when the call was sold The investor MUST deliver (sell) 100 shares of XYZ at the strike price of $55.00 per share. Delivering the shares incurs a taxable event for the investor. 8 CAPITAL MARKETS

9 How to Use Covered Call Options (continued) Assuming that the call option wasn t bought back by the investor or the investor wasn t previously assigned, the following scenarios are possible at expiration: 1. The call option expires worthless: If XYZ stock closes at or below the call strike price ($55.00), the call option will expire worthless. With respect to the option premium, the investor will recognize a capital gain of $150 The investor continues to hold the XYZ shares of stock 2. Investor gets assigned: The investor MUST deliver (sell) 100 shares of XYZ at the strike price of $55.00 per share. Selling the shares incurs a taxable event for the investor. 9 CAPITAL MARKETS

10 Factors Influencing Call Option Pricing There are numerous factors that determine the price (value) of a call option. Many of these factors are interrelated and the change in value of one or more of these factors can cause the value of a call option to change abruptly. The table below is used to illustrate some key pricing relationships and the potential change in the value of the call option. It IGNORES pricing interrelationships and assumes that only one factor changes at a time. Factor Increased time to maturity Higher stock volatility Higher interest rates Higher dividend yield Higher strike price Price of a call option Increases Increases Increases Decreases Decreases 10 CAPITAL MARKETS

11 Covered Call Options Profit and Loss Chart Profit potential is limited to the premium received by the investor Forgo upside stock price appreciation above the strike price, if assigned +Δ% POSITION VALUE AT EXPIRATION Position value Call Strike Yield from option premium is realized if the strike price is not reached the option expires worthless Partial downside protection to the extent of option premium received 100% -Δ% Stock Price at Maturity Underlying Stock Short Call & Stock 11 CAPITAL MARKETS

12 Covered Call Option Investment Considerations If an investor is assigned, he/she is obligated to sell the underlying shares of stock at the call option strike price In return for the option premium received by the investor, if assigned, the investor is OBLIGATED to sell (deliver) the underlying shares of stock at the call strike price. Please note, an investor can 1) deliver the underlying shares of stock held in his/her account or 2) purchase shares of stock from the market and deliver those shares instead. An investor limits the upside potential of the underlying shares of stock If the stock price has appreciated above the call option strike price, the investor will forgo all stock price appreciation above the call strike price because the investor has set a selling price on the underlying stock at the call option strike price. If the stock appreciates sufficiently, a stock position without a covered call could outperform a covered call position. An investor can incur large capital losses The value of the call option will change over time. Investors who buy back the call option (to close out the positions) may incur significant capital losses if the value of the call option has appreciated. 12 CAPITAL MARKETS

13 Covered Call Option Investment Considerations (continued) An investor is exposed to stock price depreciation If the stock price decreases by more than the amount of call option premium received, the investor will have 1:1 downside exposure on the underlying shares of stock. A taxable event occurs if : 1. The option is bought back - If an investor buys back the call option prior to expiration, a capital gain/loss is incurred on the call option position 2. The option expires worthless - If the call option expires worthless, the investor will incur a capital gain with respect to the option premium received when the calls were sold 3. The underlying shares of stock are sold (i.e. delivered via an assignment) - If the investor is assigned, the investor will trigger a tax event on the underlying shares of stock 13 CAPITAL MARKETS

14 Additional Information If you are looking to generate income, establish an upside but capped selling price for a particular stock or to partially reduce the risk of stock ownership, to the extent of any option premium received, you may want to consider writing covered calls. Please consult with your Morgan Stanley Financial Advisor for more information on covered call writing or to determine if these strategies are suitable for you and if they suit your particular investment needs. See the Options Industry Council s website for additional information on covered call writing and other strategies that you may wish to consider: 14 CAPITAL MARKETS

15 Key Risks and Considerations of Writing Covered Call Options Opportunity Cost/Stock Ownership The seller (writer) of a covered call forgoes the opportunity to benefit from an increase in the value of the underlying stock above the option strike price, but bears the risk of a decline in the value of the underlying security. Over different periods of time, a long stock position may outperform a covered call strategy. Equity/Market Risk Option prices are driven by several factors, one of which is the price of the underlying stock. If the price of the underlying stock increases or decreases, the value of the option contract may change. An increase or decrease in market and/or stock volatility is also likely to affect the price of an option contract. Assignment may occur at any time during the life of the option. If the call is assigned, the call option seller (writer) must deliver the underlying stock. Reduced Returns - buying back calls options or selling different call options with a different strike price and/or maturity, will likely result in added commissions, which could reduce returns. Taxable Event The sale of the stock through an option assignment or the closing of an option position may produce tax consequences. Please consult with your Tax Advisor prior to entering into any transactions. 1 Qualified Covered Calls Certain in-the-money covered calls options are deemed unqualified and carry certain tax consequences. You should consult your Financial Advisor or Tax Advisor. The outlook for the broader market or the underlying stock may change. There is no guarantee that these strategies will succeed. This information is intended to illustrate products and services available. The strategies do not necessarily represent the experience of other clients, nor do they indicate future performance. Investment results may vary. The investment strategies presented are not appropriate for every investor. Individual clients should review with their Financial Advisors the terms, conditions and risks involved with specific products or services. Past performance is no guarantee of future results. 1 Morgan Stanley Smith Barney LLC, its affiliates and Morgan Stanley Financial Advisors do not render advice on tax and tax accounting matters to clients. This material was not intended or written to be used, and it cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer under U.S. federal laws. You should always consult your own legal or tax advisor for information concerning your individual situation. 15 CAPITAL MARKETS

16 Covered Call Options Disclosure and Risks Options may not be suitable for particular investors. Before engaging in the purchase or sale of options, potential clients should understand the nature and extent of their rights and obligations and be aware of the risks involved, including, without limitation, the risks pertaining to the business and financial condition of the issuer of the underlying security/instrument. Options investing, like other forms of investing, involves tax considerations, transaction costs and margin requirements that can significantly affect clients potential profits and losses. The transaction costs of options investing consist primarily of commissions (which are imposed in opening, closing, exercise and assignment transactions) but may also include margin and interest costs in particular transactions. Transaction costs are especially significant in options strategies calling for multiple purchases and sales of options, such as multiple leg strategies, including spreads, straddles and collars. If a client is considering engaging in options trading as part of their investment plan, the Financial Advisor or Private Wealth Advisor is required to provide the client with the "Characteristics and Risks of Standardized Options" (ODD) booklet published by the Options Clearing Corporation. Clients should not enter into options transactions until they have read and understood the ODD Disclosure Document, as options are not suitable for everyone, and discussed transaction costs with the Financial Advisor or Private Wealth Advisor. A copy of the ODD is also available online at: Supporting documentation for any claims (including any claims made on behalf of options programs or the options expertise of sales persons), comparisons, recommendations, statistics, or other technical data, will be supplied upon request. Covered Call Risks Options are not suitable for all investors; therefore the covered call strategy may not be suitable for all investors. Some of the risks of covered call writing are the following: 1. An option writer may be assigned at any time during the life of the option, including the day written, regardless of the in- or out-of-the-money status of the position. 2. If the short call is assigned, the writer must deliver the underlying security. 3. The writer of a covered call forgoes the opportunity to benefit from an increase in the value of the underlying security above the option strike price, but continues to bear the risk of a decline in the value of the underlying security. 4. Buying back a call to close an existing position and writing another call with a different strike price and/or expiration, also known as rolling, can have an adverse impact on the profitability of the account. Rolling will result in added, transaction costs which will reduce returns or add to any losses. Note: It may not be prudent to continually roll positions at a loss. 5. If a secondary market in options becomes unavailable and prevents a closing transaction, the options writer's obligation would remain until expiration or assignment. 6. The sale of the stock through an option assignment or the closing/expiration of an option position may produce a tax consequence. Please consult with your Tax Advisor prior into entering any transactions. The indexes are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only. Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies. 16 CAPITAL MARKETS

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