Call options are an interesting tool for investors to keep in their tool kit. How can they be used? There are two main ways. As we discussed in my last blog, whether you’re a buyer or seller matters. Sellers of options may benefit from 1) income generation and buyers have 2) a speculative play. So, let’s look further at each of these.
What is a Call Option?
But first, what is a call? A call option gives the buyer the right, but not the obligation, to purchase equity shares on, or in some cases before, a given expiration date for a given price.
Investors who hold an equity portfolio can sell out-of-the-money calls against their stock in an effort to generate income from the option premiums paid by buyers. Their goal is to generate income on top of their equity holdings. A secondary benefit is the addition of the short call may serve to dampen the volatility of the portfolio.
Generally speaking, in moderately flat and declining markets, call sellers will likely keep the call option premium (generating income) because the price of the underlying stock does not reach the strike price before the options mature—and the options expire out-of-the money.
For illustrative purposes only.
However, in sharply rising markets, the call will generally be exercised. In which case, the investor (or call seller) may need to deliver or otherwise sell their underlying shares to offset the call’s liability if it expires in-the-money.
A key consideration for any investor selling calls is risk management. To mitigate a “melt-up” risk, investors could sell only calls on shares they own or on equity indexes that are highly correlated to their portfolio. By doing the opposite, or shorting a naked call, the investor must buy the stock at market price to satisfy an exercised call creating potentially unlimited risk.
For buyers, calls offer a speculative opportunity . . . which many investors think is a bad thing. I will not argue that point here, but I will say that buying calls is similar to owning a lottery ticket. The point of buying calls is to gain exposure to a stock for a fraction of the actual cost of owning the shares outright, so the investor can be leveraged in pursuit of outsized gains. Calls provide the potential for large scale returns under a very specific scenario, however, buyers could lose their investment under most other scenarios. I would “call” this the definition of speculation and it’s probably not a viable strategy for most investors!
The bottom line
As you can see, calls provide investors with an investment tool and there are two distinct ways to use them. When accessed prudently, they can help generate income in negative, flat and moderately advancing market environments. Calls can also be used in a speculative manner to gain upside exposure to equity shares.
Potential Parametric solution
Our DeltaShift Strategy is a managed call-option-writing program that seeks to enhance total return and reduce volatility in an equity portfolio. It can be implemented with concentrated stock positions, diversified equity portfolios, or passive indexing strategies. We seek to shift the risk-return profile of a long-equity portfolio without adjusting holdings or allocations.
Tom Lee, CFA, Managing Director, Investment Strategy & Research
Mr. Lee leads the investment team that oversees investment strategies managed in Parametric’s Minneapolis and Westport, Connecticut, offices. In his current position, Tom directs the research efforts that support existing strategies and form the foundation for new strategies. He is also chair of the Investment Committee that has oversight of these strategies. Tom has coauthored articles on topics ranging from liability-driven investments to the volatility risk premium. Prior to joining Parametric in 1994*, Tom spent two years working for the Federal Reserve in Washington. He earned a BS in economics and an MBA in finance from the University of Minnesota. He is a CFA charterholder and a member of the CFA Society of Minnesota.
*Reflects the year employee was hired by The Clifton Group, which was acquired by Parametric Portfolio Associates® LLC on December 31, 2012.
Note: The effectiveness of the option strategy is dependent on a general imbalance of natural buyers over natural sellers of index options. This imbalance could decrease or be eliminated, which could have an adverse effect. A decision as to whether, when and how to use options involves the exercise of skill and judgment, and even a well-conceived and well-executed options program may be adversely affected by market behavior or unexpected events. Successful options strategies may require the anticipation of future movements in securities prices, interest rates and other economic factors. No assurances can be given that the judgments of Parametric in this respect will be correct.
Options are not suitable for all investors and carry additional risks. Selling call options could limit investment gains if the price of the underlying advances beyond the call strike price. In addition, the downside protection afforded by call writing is limited to the amount of the premium received less costs incurred to settle the options. Investors must ensure that they have read and understood the current options risk disclosure document before entering into any options transactions. In addition, investors should consult with a tax, legal and/or financial advisor prior to contemplating any derivative transactions. The options risk disclosure document can be accessed at the following web address: http://www.optionsclearing.com/about/publications/character-risks.jsp.