Selling options on stock in RRSPs is risky way to boost returns

Option trading is widely considered a high-risk proposition and one too risky to use with RRSP investments.

But the Canada Revenue Agency does allow Canadians to employ call and put options in their RRSPs.

One example of using options is the practice of writing covered calls, which can be used to boost returns when the price of a stock held in an RRSP is going nowhere or falling in the short term — even if it is expected to rise over the years.

Let's start by defining some terms.

An option is a contract that gives the person who bought the option the right — but not the obligation — to buy or sell an underlying asset — in this case, a stock — by a certain date at a certain price

When the person who bought the option is exercising the right to buy an asset, the option is called a call. When he or she is exercising the right to sell an asset, the option is called a put.

The price of an option generally reflects the market's consensus of where the asset's price is headed, so someone would buy a call if he or she was more optimistic than most other people that the underlying stock would go up in price.

You might, for example, buy a call option giving you the right to purchase 100 shares of Tim Hortons common stock at a price of $50 a share.

Let's say you pay $210 for the contract, which gives you the right to buy the shares any time over the next seven months. The stock rises to $55. You exercise your right and purchase the shares for $5,000.

You're ahead by $230. That's the $5,500 the stock is worth minus the total of three things: the $5,000 purchase price, about $60 in commissions (let's say you're a frequent trader using an electronic brokerage service) and the $210 you paid for the call option.

Writing a covered call is different from the above example because it involves selling a call option.

Here are three more definitions: Writing is broker-speak for selling. Covered means you already own the underlying stock on which you are selling the option. And the price at which the call option buyer can buy the shares is called the strike price.

So, writing a single covered call contract means you sell somebody else the right to buy 100 shares of a stock held in your RRSP at a certain strike price at any time out to a certain date.

For example, let's say you buy 100 Suncor Energy shares for $3,200 with funds you hold in your RRSP. At the same time, you sell a call option with a strike price of $34 that expires in six months and get paid $150 for doing that.

If the stock fails to rise to the strike price, you get to keep the money paid by the call buyer as well as the stock itself. (No call buyer will exercise an option to buy a stock for more than it's worth on the open market.)

You've earned an annual return of nine per cent on a stock the price of which hasn't moved much.

The risk is that you are forced to sell your stock at less than the market price.

"The idea is to have a little more income in your account," said Neil McCammon, vice-president of trading at the Vancouver-based online discount brokerage Qtrade Investor.

Option trading is something you want to do only if you are not bullish on the stock, he said.

Qtrade vice-president Joel Bernard says it's a good idea to be aware of exactly how movements of the market will affect your call option and the shares you hold.

"The worst that can happen is the stock goes to the moon, and you've sold it at a far lower price than you would have got if you hadn't written the call," Bernard said.

"On the other side, if it goes down, you'll have lost slightly less, because you'll have gotten that little premium from selling the call."

The key to managing the risk of having the stock soar and having to sell for much less is to only sell a call that has a strike price that gives you a worthwhile return after commissions even if the call purchaser does exercise his or her right to buy the stock.

The consolation of losing out on a big gain is that at least you made something.

Let's go back to the example of buying 100 Suncor Energy shares for $3,200. You set a target for yourself of getting at least a 15 per cent annualized return.

Again, let's say you sell a call option with a strike of $34 and get paid $150. Supposing in six months the price goes to $35, the call buyer exercises his or her option, and you lose your stock, getting paid a dollar less per share than the market price of the stock.

You've still made $200 above the original purchase price plus the $150 you were paid for selling the call option minus, let's say, $90 in commissions. That's a return of 16 per cent, when extrapolated out over a year.

Compounding that higher return for several stocks over the life of your RRSP can considerably increase the size of your retirements savings.

But Louis Gagnon, a professor of finance at Queen's School of Business in Kingston, Ont., says he would do his utmost to dissuade small investors from using option trading strategies in their RRSPs.

"In the context of an RRSP investment strategy, it's not a very natural transaction," he said. "It's a gamble."

RRSPs are meant to be vehicles for building retirement savings by investing "for the long haul," Gagnon said.

"[A] covered call strategy is very short-term in nature," he said. "It's really the kind of strategy you would enter into if you didn't believe that the underlying asset were to rise in value."

And if you believe that, Gagnon asks, "why invest in the underlying stock to begin with?"

There are other risks associated with selling covered calls besides missing out on an unexpected gain in the stock's value.

High commissions can negate many of the benefits.

And the values of options tend to be less volatile when trading in the underlying stock is flat, making it difficult to get a decent return for selling a call.

For the same reason, it's also a strategy that is difficult to benefit from consistently without being disciplined about sticking to your targets for acceptable returns.

And using options changes your asset mix, increasing the riskiness of your overall portfolio.