Many people have considered options as an exotic and sometimes risky investment alternative. However, used properly, they can 1) protect your investments, 2) provide greater portfolio income, 3) permit you to take leveraged positions, with limited risk and 4) permit greater portfolio diversification. In Canada options are traded on the Montreal Exchange and in the USA they are traded on the Chicago Board Options Exchange. While there are a number of different securities or commodities that can be the underlying interest for an option, we will focus on Canadian Stock Options and some of the strategies that are used in order to derive one or more of the benefits listed above. In the discussion below, it is assumed that the reader has a basic understanding of what options are and how they trade. Because commissions vary, they will not be considered in the discussion.

In spite of the extreme volatility we have seen in bank stocks over the past few years, they are still considered relatively conservative investments and pay attractive dividends. The following example will discuss some options strategies for the CIBC (CM). Prices will be those near the close on February 10, 2010. When buying an option the offered price will be used and when selling, the bid price will be used. The portfolio is adequate margin for any positions requiring it.

CIBC Stock Price: $63.79

CIBC Price Chart

Scenario #1. You own 1000 shares of CM. You purchased the shares back in September close to $60 and have watched them move up to about $70 and then decline. Long term, you like the bank with its 5.5% dividend and you feel it will trade in a fairly narrow range for the foreseeable future.

The March $64 calls are bid $1.63. You “write covered calls ” whereby you sell 10 call options to match your 1000 shares. You may view this cash as reducing your cost base down from $60 to $58 37. If the calls are exercised before the third Saturday in March you are required to deliver your shares at $64. You have made a profit of $5.63. If in fact, the options are not exercised, you continue to hold the shares and can “write covered calls” again, further reducing your cost base.

Scenario #2. You own 1000 CM shares as above and you are very concerned the market may sell off and CM will fall far below its current price. You could sell the shares or take out insurance. The March $62 puts are offered at $1.24, and you purchase 10. This protects your full 1000 share position from falling below $62 until the third Saturday in March because until that date you have the right to sell your shares (exercise the put) at $62. In this scenario, you have increased your cost base to $61.24.

Scenario #3. You do not own any CM shares but feel the market has had a good run and it will sell off, hitting the banks particularly hard. You purchase 10 March $60 puts at 0.89. Let’s say sometime before expiry, the share price has declined to $56, you sell your shares (exercise the puts) at $60, profiting 4.00 less 0.89 per share. If the share price does not decline below $60, you have lost $0.89 per share.

Practically speaking, in all these scenarios, you have the ability to liquidate your option position any time you choose before expiry. But keep in mind that the Time Value of options decreases as we move closer to expiry. It is also important to realize that the option premium is influenced by the Hedge Ratio resulting from the rise or fall of the underlying interest.

Finally, my question to you is: have you written covered calls before? Would you like to see more articles on options strategies?

Stay In The Loop!

Subscribe to the Investing Thesis feed via RSS or Email to receive notifications when new posts are published.