Covered Call Writing Strategy for Private Foundations

By Aline Wealth Management on October 24, 2018

Kelly is a trustee on a foundation‘s board and during  a recent review of the foundation’s portfolio she learned that the portfolio’s returns were good but the income or cash flow generated by the portfolio was not enough to fund the charitable activities of the foundation –the required 5% annual distribution.   Kelly wondered if there is a conservative way to generate cash flow –given the market’s recent ascent she eschewed the notion of taking more risk (i.e. lower rated fixed income with higher yields) to generate more cash flow.

Irene, another board member mentioned an option writing strategy – where one sells options against a position in the portfolio to generate income.

Kelly thought—“Oh, options – I don’t know that sounds risky”.  But under further examination she realized that “covered call writing strategy” was indeed a conservative way to generate income.

Irene explained the strategy as the following:

Suppose the stock XYZ is currently trading at $50 in June.  A private foundation has a position (is currently long or owns) of 2000 shares of XYZ in their portfolio and the Investment Committee of the foundation decides to write (sell) a call option expiring in September (2 months from now) 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 (each option contract is equal to 100 shares hence in this case they sell 10 option contracts on the 1000 shares).  The investor’s portfolio is credited $2000 for this covered (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 on the expiration date in September at $55 a share—for that option the portfolio was immediately credited with $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 then rallies to $60 at expiration (the price movement of XYZ over the time period is not a factor—only the market closing price of XYZ on the day of expiration matters) and the call gets assigned and the foundation “delivers” the 1000 shares to the buyer of the call option (this is done via the option exchange or brokerage firm’s back office as a seamless process).  The investor 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).

However, should the stock price go down to $45, the foundation’s portfolio has received $2,000 in option premium (for 2 months)  that they 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 by an expiration date – the foundation receives cash for that right that we sold and simply waits to see if it is exercised—if it is we give them the shares – if not we can look to do it again but either way we collected the cash flow.”

Kelly then asked Courtney why she didn’t bring this to the attention of the Investment Committee before.

Courtney responded, “I did—a few years ago but at that time the committee didn’t fully understand the strategy – simply heard the word “options” and said it must be too risky”.

“What a shame—we could have been collecting a good amount of income over the last few years”, said Kelly.