Kelly is a foundation trustee who, during a recent review of the foundation’s investment portfolio, learned that income generated by the portfolio was not enough to fund the foundation’s charitable activities—the required 5% annual distribution. Although the portfolio’s returns were good, cash flow was an issue.
Kelly wondered about a conservative way to generate cash flow without taking on more risk.
Irene, another board member, mentioned an “option writing” strategy wherein one sells options against a position in the portfolio to generate income.
Kelly thought, “Options…sounds risky.” But under further examination she realized that a “covered call writing” strategy was indeed a conservative way to generate income.
Covered Call Writing
Irene explained the strategy:
Suppose the stock XYZ is trading at $50 in June. A private foundation has 2000 shares of XYZ in its portfolio. The foundation’s investment committee decides to write (sell) a call option expiring in September (2 months away) with a strike price of $55, for $2 per option. The foundation’s portfolio owns 2000 shares of XYZ but only sells options on 1000 shares. The investor’s portfolio is credited $2000 for this “covered” (i.e., because they own the underlying shares) sale of options.
Essentially the foundation has sold an option for someone to buy 1000 shares of XYZ from them at $55 per share on the expiration date—and for that option the portfolio is immediately credited $2,000.
Kelly wondered what all this meant. What happens to the foundation’s XYZ position if the shares zoom high in the next 2 months or if they come down?
Courtney, another board member who was familiar with the strategy, jumped in:
If the stock rallies to $60 at expiration (only the market closing price of XYZ on the day of expiration matters), the foundation “delivers” the 1000 shares to the buyer of the call option. The foundation now has 1000 shares less of XYZ and has received $55,000 for those shares (plus the previously received $2,000 in option premium). The shares were called away at $55 despite trading at $60 at expiration. Essentially the foundation “lost” the upside from $55 to $60 on the 1,000 shares they wrote the options against. The other 1,000 shares enjoyed the further upside to $60.
Should the stock price go down to $45 at expiration, the foundation’s portfolio has received $2,000 in option premium (for 2 months) that it would have not otherwise received and could look to sell another call option on the shares going forward. This strategy does not impede the investor from receiving any dividends on XYZ over the period up until expiration of the option.
Kelly got it. “We are selling someone the right to buy our shares in XYZ from us at a predetermined price at an expiration date. The foundation receives cash for that right and simply waits to see if it is exercised. Either way, we increase our cash flow.”
Kelly then asked why this strategy was not brought to the investment committee’s attention before.
Courtney responded, “I did a few years ago, but, at that time, the committee didn’t fully understand the strategy. They simply heard the word “option” and said it must be too risky.”
“What a shame,” said Kelly. “We could have been collecting a good amount of income over the past few years.”