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November 12, 2021

What is a Covered Call Strategy?

Making investment decisions in a volatile market can be a challenging and nerve-racking experience. But the very nature of these conditions creates unique opportunities. One way to capitalize on them is with a covered call strategy.

 

A covered call strategy involves holding a long position in a stock and then selling (or writing) a call option on the asset to generate income. The call option is a contract that gives one party (the purchaser) the right to carryout a specified transaction on a specified stock with another party (the seller or option writer). Each option has a: 

  • Strike price: The set price at which the purchaser can buy the underlying stock
  • Expiration date: The final date the purchaser can exercise their option
  • Premium: The amount the purchaser pays the seller to enter the contract. This is determined by the difference between the stock and strike price, the volatility of the underlying stock and the time to expiration. 

How does writing a call option work?

To understand how to write a call option, let’s look at an example using CI Global Asset Management’s (CI GAM) 25% covered call strategy. CI GAM writes monthly call options up to 25% of an ETF portfolio. So, if an option “contract” consists of 100 shares, the portfolio must own at least 400 shares.

 

Example: ABC Co.

 

Total number of shares

400

Stock price

$50

Strike price

$50*

Total portfolio value

$20,000

Premium

$2

Expiration date

30 days

*A strike price equal to the current stock price is called an “at-the-money” call option.

 

In this instance, since we’re writing options on 25% of the portfolio, the ETF would receive $200 as the premium (100 shares x $2). The remaining balance of the portfolio (75%) is “uncovered” and can earn capital appreciation for additional growth.

 

There are now three potential outcomes:

 

1. Pay off without exercise: If the stock price remains at $50 after 30 days, the call option will not be exercised, but the portfolio benefits from the premium received.

 

New portfolio value: original $20,000 portfolio value + $200 premium = $20,200

 

2. Break-even point: If the stock price drops to $49.50, the call will not be exercised. The portfolio value has dropped but still benefits from the premiums, bringing it to the break-even point.

 

New portfolio value: (400 shares x $49.50) + $200 option premium = $20,000

 

Any stock price below the break-even point ($49.50) will devalue the portfolio.

 

3. Pay off with exercise and capital appreciation: If the stock price rises above $50, say to $51, the calls will be exercised by the purchaser. The portfolio benefits from the premium, and capital appreciation on the 300 uncovered shares (75%) but misses the capital appreciation on the 100 exercised shares (25%).

 

New portfolio value: (300 uncovered shares x $51) + (100 shares exercised x $50) + $200 option premium = $20,500

 

Covered call strategies with CI GAM

CI GAM’s covered call strategies write monthly at-the-money call options on 25% of the ETF, which generally consists of an equal weight of companies targeting a sector or segment of the market. This time-tested process allows the strategy to generate attractive income while being exposed to the majority of upside potential.

As you can see below, the income currently being generated from the written call options and the ETFs’ dividends is substantial. In addition, the majority of the portfolios are uncovered, capitalizing on the appreciation of the underlying securities.

 

ETF

Ticker(s)

Option Yield1

Dividend Yield2

CI Gold+ Giants Covered Call ETF

CGXF

4.86%

2.33%

CI Tech Giants Covered Call ETF

TXF / TXF.B

7.42%

0.90%

CI U.S. & Canada Lifeco Income ETF

FLI

3.74%

3.39%

CI Energy Giants Covered Call ETF

NXF / NXF.B

6.05%

3.73%

CI Canadian Banks Income Class ETF

CIC

2.97%

3.65%

CI Health Care Giants Covered Call ETF

FHI / FHI.B

3.91%

1.90%

Source: CI Investments Inc., as at August 31, 2021.
1Gross Option Premiums represent those received on August 20, 2021
2The Current Dividend Yield represents the gross yield on the ETF's underlying portfolio of securities. It is not the yield, or the distribution investors will receive by virtue of an investment in the ETF.


Are covered call strategies right for you?

Covered calls are generally considered a conservative strategy because they decrease some of the risks associated with stock ownership. As we saw above, they’re also effective at generating income from the option premiums and dividend income from the underlying stock. However, the upside growth potential caps when the stock price increases above the strike price.

 

It’s also worth noting markets are currently experiencing higher than normal volatility, which has increased option premiums to levels rarely seen. This has amplified both the income benefits and downside protection covered call strategies can provide.

 

In an environment where yields are low and volatility levels are high, CI Global Asset Management Covered Call strategies provide a compelling solution to these challenges.

About the Author

Nirujan Kanagasingam


Nirujan Kanagasingam, CFA

Blog Author
CI Global Asset Management

As Vice-President of ETF Strategy, Nirujan’s primary responsibility includes working with the various departments within CI GAM to set and execute the ETF Sales Strategy and help promote the growth of the ETF business. Nirujan’s responsibilities also includes overseeing the ETF Sales Support team where he works alongside the sales team in assisting investors and advisors on ETF education and support. Nirujan brings a wealth of ETF knowledge, including ETF product management, indexing, factor research, ETF portfolio development, and has been involved in the launch of many ETFs in the Canadian marketplace. Prior to joining CI GAM, Nirujan held progressively senior roles with global asset managers Invesco and Horizons ETFs, where responsibilities included product management, product development and sales strategy in both the Canadian and U.S market. Nirujan holds a Bachelor of Commerce (Finance and Accounting) from Ryerson University and is a CFA Charterholder.

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Published November 1, 2021