The example below gives a brief overview of how a call overwriting product works.
A fund manager wishes to enter into a call overwriting strategy on a share he owns in his portfolio, which he expects to be stable or mildly performing over the short term but with good prospects over the longer term. If on the date of entering the strategy the share price is 100p, the manager decides to sell a 3 months call option with a strike of 105p. As a result of this sale, the manager receives a premium of 2p.
In 3 months time, two different scenarios are possible:
If the share is at or below 105p, the call option will expire unexercised, as the buyer of the option is given the right to purchase the share at 105p at that time while that same share is available at a lower price on the open market. For the fund manager, this strategy has outperformed by the level of the premium received, i.e. 2p (see green hashed zone below) compared to a buy and hold strategy. For example, if the share falls over that three months period to 93p, a buy and hold strategy would result in a loss of 7p to the fund manager, while the call writing strategy results in a loss of only 5p to the fund manager, i.e. an out-performance of 2p.
If the share is above 105p in 3 months time, the call option will be exercised on the expiry date, as the buyer of the option is given the right to purchase the share at 105p at that time while that same share is more expensive in the open market. For the fund manager, the strategy will have underperformed a straight-forward tracking strategy (see red hashed zone below), unless the premium received is high enough to compensate for that unrealized potential gain (see orange hashed zone). Note therefore that the potential gain for the call overwriting strategy is capped at 107p, i.e. a 7% return over three months. For example, if the share rises over that three month period to 110p, a buy and hold strategy would result in a gain of 10p to the fund manager, while the call overwriting strategy results in a gain of only 7p (5p from the sale of the share when the option is exercised plus 2p from the original sale of the call option). In this case there is an under-performance of 3p.