Creating an Income Stream for Your Clients: The Art & Science of

Covered Call Writing

David Salloum MBA CFP CIM FCSI TEP

Vice President & Portfolio Manager

Objectives

Review the basic terminology, concepts and characteristics associated with various derivative instruments

Describe the different factors that influence the option’s premium

Describe and illustrate this basic option strategy as well as the inherent risk and reward potential

Presentation Summary

Introduction Options Covered Call Writing Question Period

Things to Keep in Mind

For any transaction to take place there needs to be a willing buyer and a willing seller.

Interest rates change. Stock prices change.

“By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivatives…these instruments are an increasingly important vehicle for unbundling risks. They enhance the ability to differentiate risk and allocate it to those investors most able and willing to take it… this process has undoubtedly improved national productivity growth and standards of living.”

Alan Greenspan, Chairman of the U.S. Federal Reserve Board of Governors, 1987-2006

Definition

Derivative instruments are financial instruments that derive their value from the value of an underlying asset, namely:

a stock, an index, a bond, an interest rate, a currency, a commodity.

Definition

Derivatives are contracts or agreements to purchase or sell assets at a future date.The contracts specify in advance:

the underlying interest the quantity/amount the purchase or sell price the expiry date of the contract

Why do they use derivatives?

To attain investment objectives Income strategy Free up cash Protect capital

Exchange Market

Broker

Clearing Corporation

RISK

Exchange Market Broker

Margin Margin

CLIENT A CLIENT B

Elements in an Option Contract

Type: call or put.

Underlying interest: the underlying asset specified in the option contract.Expiry month: the month during which the option ceases to exist (options expire on the Saturday following the 3rd Friday of each month).Strike price: the price at which the holder can purchase or sell the underlying.Premium: the option’s price (x multiplier: 100 for stock options).

Call Options

The buyer (holder) of a call option has the right, but not the obligation:

to buy a specific quantity of an underlying; at a given price (strike price); for a specified time period (expiry date).

In order to obtain this right, the holder must

pay a premium to the writer.

Call Options

The seller (writer) of a call option has the obligation to sell to the holder:A specific quantity of an underlying;At the strike price indicated, if the holder exercises his right.

In return for this obligation, the writer receives the premium paid by the holder.

The Options Market

Call Put

Holder/Buyer(pays a premium)

Right to buy

(no obligation)

Right to sell

(no obligation)

Writer/Seller(receives a premium)

Obligation to sell Obligation to buy

Your Options

The holder of the option can: Exercise his right to buy or sell Close his position by selling back the option Let the option expire worthless (loss)

The seller of the option can: Accept to be assigned (deliver or take delivery) Close his position by buying back the option Let the option expire worthless (gain)

Basic Strategies

Calls Puts

Buy

(Holder)

To benefit from a price increase

To determine the future acquisition price

To hedge a short sale

To benefit from a price decrease

To determine the future selling price

To hedge a long position

Sell

(Writer)

To benefit from a price decrease

To generate additional income

To benefit from a price increase

To generate additional income

The Option Chain

Call CM July 105 @ $2.00

Option type

Underlying asset

Expiry month

Strike price

Option premium

Call Options

April 07: G @ $29.63

Buy 1 Call G July 30 @ $2.20

Sell 1 Call G July 30 @ $2.20

Right to buy

Obligation to sell

Call Options

Buyer 1 Call G July 30 @ $2.20

Seller 1 Call G July 30 @ $2.20

Scenario 1: At expiration, G @ $36

Scenario 2: At expiration, G @ $26

Exercise Styles

American-style options: allow the holder to exercise at any time during the life of the option (all stock options and few index options).

European-style options: limit the holder to exercise the option only at expiry date (most index options).

In, At, Out…

Out-of-the-money

Call

Strike$62

Strike$58

Put

Strike $58

In-the-money

At-the-money (strike $60)

Strike $62

In-the-moneyOut-of-the-money

Intrinsic Value

Intrinsic Value

Market PCA = $60

Market PCA = $60

Factors Influencing the Option Price

Premium=Intrinsic Value + Time Value Intrinsic Value: is the amount by which the option is in-

the-money. Time Value: an option is a wasting asset; its value

declines over time. Time to expiration Volatility Risk-Free Interest Rate Dividends

What’s the value of an option at expiration?

Factors Influencing the Option PriceVolatility

Volatility measures the amount by which the price of the underlying stock fluctuates during a specified period of time.

The higher the volatility, the higher the option’s premium.

The Options Market

April 2007: SLF @ $53

Call July 50 is trading @ $3.95 Intrinsic value? $0.95 Time value?

Factors Influencing the Option Price Time to Expiration

RIM is trading @ $168.85 (April 07) Call RIM May 170 @ $9.15 Call RIM September 170 @ $18.55

The more time to expiration, the higher the value of the call.

www.m-x.ca

Options Guide and Strategies Options Newsletter Options Calculators Covered Call Calculator Quotes and Implied Volatility Options summary

Options MontageSymbol: TD Calls & Puts

TD-T L 73.51 Chg -0.74 B 73.50 A 73.51Opn 73.85 Hi 74.00 Low 73.26 AH 74.89 AL 55.62PCls 74.25 EPS 4.63 PE 15.88 Div 2.12 Yld 2.88%%Chg -1.00% CE 1.37 FPE 13.48

Y/M/S Last Change Bid AskOCT072 3.80 - 3.45 3.60OCT074 2.85 - 2.25 2.45OCT076 1.50 -0.35 1.35 1.55OCT078 1.15 - 0.75 0.95

Last Trade Price

Covered Call Writing WorksheetIn the Money At the Money

Out of the Money

Buy 1000 shares TD @ 73.51$ = 73,510.00$

Total A 73,510.00$

Total Investments (A-B) = 69,710.00$

If Exercised

Sell 1000 shares TD @ $72 D 72,000.00$

Profit (D-C) E 2,290.00$

Sell 10 OCT 72.00$ calls @ $3.80 B 3,800.00$

In 138 days = 3.29%

Annualized = 8.93%

Annual Dividend 2.12$ # Dividends Received 2 = 1.06$

Dividends 1.06$ X 1000 = 1,060.00$ = 1.44%

Total Annual Return 10.37%

74.00$ calls @ $2.85 B 2,850.00$

70,660.00$

@ $74 D 74,000.00$

3,340.00$

4.73%

12.99%

1.44%

14.43%

78.00$ calls @ $1.15 B 1,150.00$

72,360.00$

@ $78 D 78,000.00$

5,640.00$

7.79%

21.96%

1.44%

23.40%

Options MontageSymbol: TRP Calls & Puts

TRP-T L 38.78 Chg -0.57 B 68.76 A 38.78Opn 39.17 Hi 39.25 Low 38.54 AH 41.35 AL 31.35PCls 39.35 EPS 2.17 PE 17.87 Div 1.36 Yld 3.51%%Chg -1.45% CE 0.47 FPE 18.91

Y/M/S Last Change Bid AskOCT036 4.40 - 3.15 3.25OCT038 2.30 - 1.70 1.85OCT040 1.10 - 0.75 0.85OCT042 0.35 - 0.25 0.30

Last Trade Price

Covered Call Writing WorksheetIn the Money At the Money

Out of the Money

Buy 1000 shares TRP @ 38.78$ = 38,780.00$

Total A 38,780.00$

Sell 10 OCT 36.00$ calls @ $4.40 4,400.00$

Total Investments = 34,380.00$

If Exercised

Sell 1000 shares TRP @ $36 D 36,000.00$

Profit (D-C) E 1,620.00$

In 138 days = 4.71%

Annualized = 12.95%

Annual Dividend 1.36$ # Dividends Received 2 = 0.68$

Dividends 0.68$ X 1000 = 680.00$ = 1.75%

Total Annual Return 14.70%

38.00$ calls @ $2.30 B 2,300.00$

@ $38 D 38,000.00$

1,520.00$

4.17%

11.40%

1.75%

13.16%

40.00$ calls @ $1.10 B 1,100.00$

36,480.00$

@ $40 D 40,000.00$

2,320.00$

6.16%

17.12%

1.75%

18.87%

37,680.00$

Options MontageSymbol: CCO Calls & Puts

CCO-T L 57.58 Chg 1.28 B 57.55 A 57.58Opn 55.66 Hi 57.58 Low 55.61 AH 57.49 AL 35.35PCls 56.3 EPS 0.92 PE 62.59 Div 0.20 Yld 0.35%%Chg 2.27% CE 0.39 FPE 30.15

Y/M/S Last Change Bid AskOCT054 6.60 1.55 6.5 6.7OCT056 5.45 0.85 5.35 5.5OCT058 4.15 - 4.35 4.45OCT060 3.3 - 3.5 3.65

Last Trade Price

Covered Call Writing WorksheetIn the Money At the Money

Out of the Money

Buy 1000 shares CCO @ 57.38$ = 57,380.00$

Total A 57,380.00$

Sell 10 OCT 56.00$ calls @ $5.45 B 5,450.00$

Total Investments (A-B) C 51,930.00$

If Exercised

Sell 1000 shares CCO @ $56 D 56,000.00$

Profit (D-C) E 4,070.00$

In 138 days = 7.84%

Annualized = 22.09%

Annual Dividend 0.20$ # Dividends Received 2 = 0.10$

Dividends 0.10$ X 1000 = 100.00$ = 0.17%

Total Annual Return 22.26%

58.00$ calls @ $4.15 B 4,150.00$

53,230.00$

@ $58 D 58,000.00$

4,770.00$

8.96%

25.48%

0.17%

25.65%

60.00$ calls @ $3.30 B 3,300.00$

54,080.00$

@ $60 D 60,000.00$

5,920.00$

10.95%

31.62%

0.17%

31.79%