Covered Calls

After the recent wholesale culling of dividends on FTSE 100 stocks. I know a lot of income-focused investors have been despairing of where — and when — their next dividend payment is going to come from. Well, if you have followed my recent posts, you will know that I have been suggesting savvy investors check out Instant Dividends. Or, as they are technically known in the business, a covered call.

A covered call is a straightforward trade that you can carry out if you buy — or already own — many of the stocks that call the FTSE 100 home. In essence, you initiate a contract that obligates you to sell your shares for a profit, if the share price rises above a price of your choosing. And within a timeframe of your choosing. In return for that commitment, you receive a nearly instant dividend-like payment.

Sounds great. But what does one of these transactions actually look like? Well, let’s take a look at one recent dividend offender to see.

An example

ITV Plc was trading today at 68p per share. That’s a hefty drop from it’s recent high and they have also cut the dividend. But, the shares have been recovering of late along with the wider market. Remember, I’m making no recommendation here, just showing you what is possible.

If you were to buy 1,000 ITV shares at 68p each, you could also have sold a July covered call with a strike price of 75p. You would be paid 4.5p per share.

You are then obligated to sell your shares for 75p each (a 7p profit) if the share price rises above that level by the 17th of July. And you will be paid 4.5p in return. That’s a 6.6% yield from the call, in return for an 86-day commitment. Not too shabby.

Possible outcomes

But what are the possible outcomes at the July expiration date?

  • #1: If the share price rises above 75p. Your shares will be sold for a 7p profit and you get to keep the 4.5p you made from selling the covered call.
  • #2: If the stock ends up between 68p and 75p. You keep the shares — and the unrealised profit — and you get to keep the 4.5p you made from selling the covered call.
  • #3: If the share price stays bang on 68p. You retain the shares and you get to keep the 4.5p you made from selling the covered call. Can you see a pattern emerging?
  • #4: If the share price drops to 63.5p. You keep the shares but will break even on the overall position because the 4.5p covered call premium offsets the drop in the share price.
  • #5: And finally, if the share price drops below 63.5p. You will be showing an unrealised loss on the shares, but it will be offset to some extent by the 4.5p premium you made from selling the call.

Or, to put it another way, you are always better off selling the covered call than simply buying the shares, unless the share price shoots way up. And in that case, you would still make 11.5p for your 86-day commitment. That equates to a 16.9% return.

Are you still as worried about losing the regular dividend?

If you like the sound of Instant Dividends then why not Google ‘covered calls’ or check out the free resources here and  here.

Third Friday Ltd are not regulated by the Financial Conduct Authority and the FIRE Revolution training programme is purely educational in nature. Under no circumstances do we provide any financial trading or investment advice. Any examples used are for educational purposes only and should never be construed as advice. We accept no responsibility for any investment losses you may incur. Please consult a financial advisor or other qualified professional if you are in any doubt as to the suitability of the strategies we teach.