Don't be scared of derivatives

Times are tough for income seekers. Although sectors such as banking and telecoms offer average dividend yields of 7% or more, Punch Taverns recently showed the risk that goes with such apparent generosity after it joined the growing list of companies scrapping or cutting dividend payments. But all is not lost for equity investors prepared to do a bit of homework. A strategy familiar to many fund managers selling 'covered' call options can generate decent up-front income and juicy returns for relatively little risk. Here's how it works.

Options revisited

The mere mention of derivatives can send nervous investors into a tailspin. But fear not, basic options share several similarities with a product most of us happily use insurance. In both cases there is a buyer who pays an up-front premium (and then literally 'holds' the contract, hence the other common term 'holder') and a seller who receives the same premium (and must have written the contract before selling it, hence the term 'writer'). Holding a car insurance policy gives you the right to call the insurer and demand compensation should your car then be damaged or written off. The price you pay for this right is a non-refundable premium. Unused car insurance simply expires and must be renewed.

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Similarly, paying for an equity 'call option' gives you the right to buy a fixed number of shares at, or by, a future date, at a pre-determined fixed 'strike' price. Should the market price of those shares rise above the strike it makes sense to 'call' in shares from the option writer and sell them on at a profit. If instead the share price sinks like a stone, you can abandon the option and sacrifice the premium. An alternative is to hold a 'put'; the right to sell, say, 1,000 shares for a fixed price within the next three months. Again, should the market price of the underlying shares fall well below that fixed 'strike' it makes sense to buy in the open market and then deliver them to the writer of the contract for a profit.

But here's the clever bit. In the world of car insurance you only ever get to buy (or 'hold') a policy. But in the world of options, you can buy ('hold') or sell ('write') them. In other words, you can play the role of the insurer, taking an up-front premium from another investor in the hope that they never exercise the option before it expires.

Introducing the covered call option

One half of this strategy involves selling call options that give someone else the right to demand from you delivery of shares at a fixed price. The second half is making sure the options are written on shares you already own. Otherwise, when the phone goes you could be faced with having to buy shares in the open market for, say, £10, which the call options require you to deliver for a pre-agreed strike price of, for instance, just £2. The up-front premium you took for writing the options is highly unlikely to cover losses on that scale. But if you already own the shares, losses are limited.

Here's an example: you own 1,000 Pearson shares trading at 670p each. You sell a call option with a December 2008 expiry on the full 1,000 for a premium of 40p a share with a strike price of 680p. This is an 'out-of-the-money' option, because the share price has to rise by over 10p (680-670) to make the option useful to the holder. So if over the next three months the share price rises by just 10p, you're laughing. That's because the share price gain of 10p equates to a 1.5% return (10/670), on top of which you get to keep the 40p premium, adding roughly another 6% (40/670). That's a potential 7.5% earned in just three months.

The beauty of writing covered calls as opposed to 'naked' calls, where you don't own the underlying shares is that the downside is limited. Should the shares fall steeply in value, the premium of 40p cushions the first 6% of any fall. That beats holding the shares without having first sold the options, as you then suffer 100% of any drop.

What can possibly go wrong?

The trouble is, should the shares rise sharply before the option expires, you face having to deliver all 1,000 at the strike of 680p (you still make the first 10p of any gain) and missing out on any further rise. You can avoid this fate by buying back the option to 'close out', but this will be at a much higher premium than the 40p received, triggering a loss. That means that writing covered calls is best done on shares that you expect to remain flat (with low recent volatility) or rise slightly. So candidates to avoid include companies about to issue earnings or dividends updates, since these can cause short-term price spikes, and, for the same reason, firms that may be subject to a bid.

If, on the other hand, you are an outright bull, then it makes more sense simply to buy the shares and wait. Or, if you don't mind risking 100% of your investment in lost premiums if you get it wrong, go for much bigger gains by buying a call option this will serve up a huge return should the share price then surge beyond the pre-set strike price.

How to do it

Call options can be bought and sold through a number of UK brokers, including IG Index. Your dealing costs come in the form of a bid-offer spread based on the option premium, so an option with a premium of 40p might be priced at 38-42, meaning you get 38p for writing it. If the underlying shares then rise in price, pushing the premium up to, say, 55p, the spread might move to 53-57. Should you close out at 57p to avoid having to deliver the shares being called, you have suffered a total spread of 4p on top of a trading loss of 15p. Lastly, be aware that 'covered warrants', which are marketed as being similar to options, are not as suitable for "covered call writing" UK private investors can only hold, not write them, under UK regulations.