Protected covered write: strategy guide

Key features

• A Leveraged Margin Loan with Exchange Options Plus allows investors to borrow up to 100% of the put option strike price. The cost of the put option is partially offset from the proceeds of the sold call option on the share. The strategy therefore allows investors to gain a larger geared exposure for a smaller outlay
• The put option protects the downside risk on the stock
• The strategy is most suitable when share prices are expected to rise moderately

Case study

Jason is interested in buying 1,000 shares in company A, currently trading at $73.00. He decides to utilise the 100% borrowing feature from Leveraged and purchases a put option to cap his downside risk.

To implement this strategy, Jason purchases a put option with a strike price of $73.00, which will expire in 227 days. Jason is also prepared to sell his shares in Company A, should the share price increase to $90.64, so he sells a call option at that strike price. He plans to use the proceeds received from the sold call option to offset part of the cost of the protective put option.

*Dividends and franking credits are not received upfront on the trade.

For a 1,000 share holding in company A Jason will need to invest $2.77 x 1,000 = $2,770. This will give him an equivalent exposure of $73,000. $2,770 is also the estimated maximum loss on the investment as the loan is fully protected by the purchased put option.

What happens if the shares decline in value?

Let’s assume Company A’s shares decline to $60.00 at expiry. Jason will be able to sell his Company A shares at the put option strike price of $73 to repay his loan.

The loss is limited to the $2.77 maximum loss. If Jason had not used the collar strategy and just purchased Company A shares, his loss would have been $13 per share ($73-$60), less the $5.88 received from the grossed up yield. Therefore a loss of $7.12 per share.

What happens if the stock remains flat?

If the stock is trading at $73 at maturity Jason’s purchased put option will expire worthless. The most he can lose in this example is $2.77 per share.

What happens if Company A shares increases in value?

Jason will be able to benefit from the appreciation in the share price. However, his upside is capped at the strike price of the sold call option, which in this example is $90.64. This is a profit of $90.64 (call option strike price) - $73.00 (purchase price) - $2.77 (interest and put option cost net of dividends) = $14.87 per share. If he purchased 1,000 shares in Company A, this is a total profit of $14,870 for a maximum risk of $2,770.

Here is the payoff for the collar strategy

Other items to keep in mind

The example above does not take tax into consideration for the loan, investments or trading strategy.

The Lending Value will be calculated on the written Call Option, whenever the Market Price of the Security multiplied by the Lending Ratio is higher than the Exercise Price of the bought Put Option, multiplied by 100 percent. As a consequence, you will be required to cover any shortfall as a result of borrowing up to the strike of the Put Option.

Should the position have a sharp move in the underlying stock before the expiry date of the option, the collar can be closed off by buying back the sold call option on the market and then selling the purchased put option and the shares held.

Given the lower capital contribution for the investment, Jason has the ability to create a more diversified exposure to the market, which may help reduce his overall portfolio risk.

There may be limitations on which call option can be sold to be entitled to franking credits on the trade. You should contact your adviser for further advice.

How to get started

Speak with your financial adviser to discuss whether options trading is right for you. To enable options trading on your Leveraged Margin Loan using Exchange Option Plus, contact your Relationship Manager or Apply Now.

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