Covered call options

aroominyork

I came across Schroder Income Maximiser OEIC while planning a retirement income portfolio. It uses covered call options, which the KIID describes by "To seek to enhance the yield, the investment manager selectively sells short dated call options over individual securities, portfolios of securities or indices held by the fund, by agreeing strike prices above which potential capital growth is sold." My understanding is that third parties pay Schroder for options; if a stock's price exceeds a certain level (strike price), the capital gain is paid to the third party. If it does not reach the strike price, the options fee increases the fund's distributed income. If that is correct, the aspect I do not understand is that the underlying assets are strongly skewed to value so there is an expectation of price rises, hence the options are more likely to be triggered. Is that correct as far as it goes, and would the response be that the options are offered by Schroder only on selected stocks, and only at strike prices that exceed the level to which Schroder believes the under-priced stock will rise?

InvesterJones

aroominyork said:

 If that is correct, the aspect I do not understand is that the underlying assets are strongly skewed to value so there is an expectation of price rises, hence the options are more likely to be triggered. Is that correct as far as it goes, and would the response be that the options are offered by Schroder only on selected stocks, and only at strike prices that exceed the level to which Schroder believes the under-priced stock will rise?

Why is there an expectation of price rises? It could be they're priced that way because they pay a dividend rather than reinvest, or the market thinks there are poor prospects for future growth.

I'd guess it's a defensive play that eeks out a little more income from volatility without going all in on shorting. If the options are so far out that schroder don't think they'll be hit, people won't buy them either.

aroominyork

I realise there is a degree of correlation between value shares and dividend payers. Are you saying that can be a long-term strategic choice by a company, that it choses to trundle on paying reliable dividends without seeking to grow... and that means it remains rooted in Morningstar's value box?

InvesterJones

aroominyork said:

I realise there is a degree of correlation between value shares and dividend payers. Are you saying that can be a long-term strategic choice by a company, that it choses to trundle on paying reliable dividends without seeking to grow... and that means it remains rooted in Morningstar's value box?

Yes (though they'll seek to grow their dividends of course). And vice versa - growth companies may chose to pay little or no dividend.

GeoffTF

aroominyork said:

My understanding is that third parties pay Schroder for options; if a stock's price exceeds a certain level (strike price), the capital gain is paid to the third party.

Schroder will lose the stock if the option expires. Schroder can avoid that by buying back the option before it expires. The cost will be the amount by which the price has risen above the strike price multiplied by the number of optioned shares, plus any remaining time value (which will be zero at expiry). The fund gains if the stock price remains below the strike price, but there is no free lunch here. The increased income is matched by the capital losses, on a risk adjusted basis. There are also additional costs. Schroder can advertise a higher income, and many of their customers will not understand that they are paying for that income out of their capital.

aroominyork

GeoffTF said:

aroominyork said:

My understanding is that third parties pay Schroder for options; if a stock's price exceeds a certain level (strike price), the capital gain is paid to the third party.

Schroder will lose the stock if the option expires. Schroder can avoid that by buying back the option before it expires. The cost will be the amount by which the price has risen above the strike price multiplied by the number of optioned shares, plus any remaining time value (which will be zero at expiry). The fund gains if the stock price remains below the strike price, but there is no free lunch here. The increased income is matched by the capital losses, on a risk adjusted basis. There are also additional costs. Schroder can advertise a higher income, and many of their customers will not understand that they are paying for that income out of their capital.

So does any excess total return over an equivalent vanilla fund such as Vanguard FTSE Equity Income Index come down to Schroder's stock picking and their selection of where to offer options?

GeoffTF

aroominyork said:

GeoffTF said:

aroominyork said:

My understanding is that third parties pay Schroder for options; if a stock's price exceeds a certain level (strike price), the capital gain is paid to the third party.

Schroder will lose the stock if the option expires. Schroder can avoid that by buying back the option before it expires. The cost will be the amount by which the price has risen above the strike price multiplied by the number of optioned shares, plus any remaining time value (which will be zero at expiry). The fund gains if the stock price remains below the strike price, but there is no free lunch here. The increased income is matched by the capital losses, on a risk adjusted basis. There are also additional costs. Schroder can advertise a higher income, and many of their customers will not understand that they are paying for that income out of their capital.

So does any excess total return over an equivalent vanilla fund such as Vanguard FTSE Equity Income Index come down to Schroder's stock picking and their selection of where to offer options?

Yes, luck basically.

Linton

GeoffTF said:

aroominyork said:

My understanding is that third parties pay Schroder for options; if a stock's price exceeds a certain level (strike price), the capital gain is paid to the third party.

Schroder will lose the stock if the option expires. Schroder can avoid that by buying back the option before it expires. The cost will be the amount by which the price has risen above the strike price multiplied by the number of optioned shares, plus any remaining time value (which will be zero at expiry). The fund gains if the stock price remains below the strike price, but there is no free lunch here. The increased income is matched by the capital losses, on a risk adjusted basis. There are also additional costs. Schroder can advertise a higher income, and many of their customers will not understand that they are paying for that income out of their capital.

Surely it's the option purchaser who loses out if the option expires before reaching the strike price? Under those circumstances the option has zero value.

AIUI Schroder sell the option for the buyer to purchase an amount of stock from Schroder at a strike price above the current price within a time period.  If the stock doesnt reach the strike price the option simply lapses, the option purchaser loses out and Schroder make a profit.

If the stock price exceeds the strike price Schroder must sell the shares to the buyer of the option at the strike price and make a book value capital loss proportional to the actual price above the strike price. So Schroder do retain some of the capital gain but lose the further capital gain they could have made.

They are selling future possible but unknown capital gains to provide current actual capital which presumably is used to purchase more income stock.

Yes, the shenanigans will result in higher costs and less total return to the fund.  But people dont buy the fund for its total return, they buy it for the ongoing current income.  If they wanted total return at some unknown future date they would not have bought the fund in the first place.

GeoffTF

Linton said:

GeoffTF said:

aroominyork said:

My understanding is that third parties pay Schroder for options; if a stock's price exceeds a certain level (strike price), the capital gain is paid to the third party.

Schroder will lose the stock if the option expires. Schroder can avoid that by buying back the option before it expires. The cost will be the amount by which the price has risen above the strike price multiplied by the number of optioned shares, plus any remaining time value (which will be zero at expiry). The fund gains if the stock price remains below the strike price, but there is no free lunch here. The increased income is matched by the capital losses, on a risk adjusted basis. There are also additional costs. Schroder can advertise a higher income, and many of their customers will not understand that they are paying for that income out of their capital.

Surely it's the option purchaser who loses out if the option expires before reaching the strike price? Under those circumstances the option has zero value.

I did not explain that well. If Schroder continues to hold the stock and option until the option expires, the stock will be assigned. That means that it is automatically sold to the option buyer (unless the option buyer has to exercise the option manually). Schroder does lose the stock, but receives money in return. If Schroder wants to continue to hold the stock, it has to buy the option back (i.e. close the short option position). (Stock options are usually American exercise, which means that they can be traded before expiry.) If Schroder wants to continue to hold the stock, it is likely to be cheaper to buy back the option, rather than have it assigned and have to buy the stock back.

Whether the option seller loses out is a matter of perspective. The option seller sells his upside for a fixed price that is more than he is expecting.

A further complication is that the option holder can exercise the option before expiry. In theory, that is never worthwhile, because the option always has some time value, but it has happened to me.

GeoffTF

There is an S&P 500 covered call index:

https://www.spglobal.com/spdji/en/indices/multi-asset/sp-500-daily-covered-call-index/#overview

The total return more or less tracked that of the S&P 500 for a long time, but has fallen away in the recent market surge. More aggressive option selling strategies do well most of the time, but occasionally do very badly.