Covered Calls

Okay, first up, what the heck is a covered call?

call is an options contract that allows the holder to buy a set number of shares, at a fixed price, within a certain time period. 

Now, if your heart sank at the word options, don’t worry, I get it. For some reason, they have gained a reputation for being complicated and risky when they really don’t deserve it. Used correctly, they actually reduce the risk of owning the already big and boring dividend stocks that I favour.

As for being complicated, they are traded on an exchange using an online brokers platform in a very similar way to shares. So, if you can operate your online banking, you’ll have no problem with selling covered calls.

covered call simply means that the seller already owns the shares they’ll need if the call holder exercises their option. That eliminates much of the risk.

When you sell a call, the buyer pays you a premium and that’s where the income comes from. It’s yours to keep whatever the outcome of the transaction. So, if you like the idea of receiving dividends twice a year, how would you like to receive option premiums as frequently as once a month?

Let’s have a look at an example.

You Got Options

XYZ Plc is a utility company in the UK. It’s a typical FTSE 100 dividend yielding stock, of the type favoured by income investors. It’s currently trading at 200p per share which equates to a reasonably well-covered forecast dividend yield of 5.0%.

Assuming you’ve done your research and like the look of XYZ Plc — you could simply buy the shares, sit back, and enjoy that 5.0% dividend income. Nothing wrong with that.

Or, for a little extra work you could supercharge that income. Here’s how:

Let’s assume that you buy 1,000 shares for a total of £2,000 plus commissions and stamp duty. You could then sell one covered call on those shares.

Why 1,000? Well, a single UK option contract represents 1,000 shares. So, that’s the minimum number you need to own in order to sell a covered call.

There are quite a few different calls available on XYZ Plc at any one time.

They have different strike prices — the price at which the holder can buy shares from you — and different expiration dates — the amount of time they have to exercise that right.

I won’t get into the nuts and bolts of why you would choose a particular combination at this time — let’s just examine a straightforward example to help get the concept across.

Supercharge Your Yield

Looking at my broker’s online platform I can see that you could sell an XYZ Plc call with a strike price of 210p that expires in two months time, for £50. That represents an annualised yield of 15% and is yours to keep whatever happens.

As the seller of the call, you are now obligated to sell 1,000 shares of XYZ Plc to the buyer of the call for 210p each, IF they exercise their option on or before the expiration date in two months time.

That’s ten pence MORE than you paid for them. Why would they do that?

Good question. The buyer of the call is hoping that the shares will shoot up in value by expiration day, and they will be able to buy them from you cheaper than they are trading on the open market.

And for that privilege, they are prepared to pay you 5p per share, or £50 in total.

What happens next?

Well, if the share price is trading below 210p on the third Friday of the expiration month , the call simply expires worthless. Your obligation is lifted, you keep the £50, and can simply sell another call if you want.

Rinse and repeat. As often as you wish.

You received £50 for a two-month commitment. That’s an annualised yield of 15% of the purchase price of XYZ’s shares.

And assuming no cuts, you will also collect any dividends due on top of that for an overall forecast annualised income of 20%. Of course, you will also be showing an unrealised gain or loss on the shares. That’s not a problem if you intend to hold the shares long-term to generate further income.

But what happens if the share price rises above 210p by expiration date?

Well, the holder of the call will likely exercise their option and you will be obligated to sell them the 1,000 shares that you own in XYZ Plc for 210p each.

That’s a grand total of £2,100. So, even with commissions and the original stamp duty you would be showing a healthy profit on the shares.

And of course, you get to keep the £50 premium the call buyer originally paid, plus any dividends. So, that’s a pretty good outcome as well.

What’s the catch?

As all good investors know, you don’t get any reward without taking a corresponding risk. So, what is the catch here — where is our risk?

The main risk that you face is from owning the shares in the first place. We all know, that shares can go down in value as well as up.

However, selling the call on the shares actually reduces the risk of simply holding the shares.

You have collected a 5p premium per share that’s yours to keep whatever happens. That can be offset against any drop in the value of the XYZ Plc shares. And the more iterations of call selling you go through, the larger the income you collect to help offset any drop in the share price.

The other risk is that the share price shoots way up. So, for example, if XYZ shares jump to 230p each by expiration day, your covered call means that you will be obligated to sell them at 210p each. Not the 230p you could get in the open market.

Of course, you would still make some profit on the shares and get to keep the premium and any dividends — so it’s hardly a bad outcome.

You are giving up some potential future upside in return for some definite income now. I think that’s a pretty good deal. After all, that extra income is yours to keep whatever happens.

If you are already a ‘buy and hold’ investor then selling covered calls and their close cousins cousins — cash secured puts — is a fantastic way to seriously boost your income whilst also reducing your downside risk and volatility. Done right, and with a reasonably sized account, it could even help you achieve your financial independence.