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Get a double-digit income on blue-chips

With the next 12 months unlikely to be as spectacular for stocks as the last 12 months,now looks like a good time to focus on income rather than capital growth. And one strategy, writing 'covered calls', can help you multiply your income massively. Theo Casey explains.

A year has passed since the FTSE 100 bottomed. On 6 March 2009, when the blue-chip index fell as low as 3,530, few pundits expected a strong recovery. Yet the market has jumped 58% since then.

However, the next 12 months are unlikely to be as spectacular. Fiscal stimulus is ending around the world and that's likely to rattle markets, even if it doesn't send them into another tail-spin. That's why now looks like a good time to focus on income rather than capital growth. And one strategy, writing 'covered calls', can help you multiply your income massively.

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How does it work? When you write a call option, you are selling an option to another trader. This trader is paying you for the right to take your stock away from you if it hits a specified higher price. The call is known as a 'covered' call, because the shares you own will cover you if you end up having to deliver on the deal. And it's the perfect strategy for times like these.

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A Callan Associates (2006) report showed that the return on a covered call strategy beats traditional benchmarks in falling markets, flat markets, and moderately rising markets. The only market condition in which covered calls are unsuccessful is a fast-rising market. Even then, the call writer does not incur a loss. Rather, they don't get to participate in the whole rally. So how does it work?

Earn an 18% income on Vodafone

Mobile-phone giant Vodafone pays a 5.8% annual dividend. Using the covered call approach, we can triple that income. Here's how. Say you bought 1,000 shares at £1.41 each on 22 February. That comes to £1,410. With a 5.8% yield you'll also get an £82 annual dividend.

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Now for the options bit. With share options, you don't trade them one by one, but in lots of 1,000. Each contract you buy is equivalent to 1,000 shares. But the premium you pay is significantly lower than the cost of buying the shares. In this case, an out-of-the-money contract for 1,000 shares with an underlying value of £1,410 and a strike price of 145p (the price at which the option can be exercised) would have set you back £15.00 on the same date. If you were buying the option, you'd have to pay this amount. But as we're writing (selling) this option contract, we receive this money. So let's recap on what you have so far:

A share holding worth £1,410. A dividend yield worth £82. A short position in an option, worth £15.

The option money is yours from the moment you write the position. That option will expire worthless in 30 days. At that point, you write another option contract, and the cycle begins again. Over the course of 12 months, Vodafone call writers can use this trick every month. That's an income of £180, on top of the £82 dividend you get over the year. All of which produces a 18.6% annual income on the UK's third-largest firm. And Vodafone's not the only stock you can use. There are 97 candidates for this strategy on the NYSE Liffe options market, including BP, Glaxo, Tesco and Unilever.

What's the catch?

If it was as easy as this everyone would be doing it, right? Well, the main risk is that you will be taken out of your underlying share holding. The option you sell is covered by the shares you own. The buyer of that option pays you cash today (the option premium) for the chance to take your stock away at the strike price. If that happens and the stock keeps rising, you'll miss the rally. So fiercely rising markets are not suited to covered calls trading.

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A bigger hurdle is the cost. While the strategy itself makes sense, you do have to be pretty well off to take advantage of it. That £15 you make on Vodafone every month will be nearly completely eaten up by the broker fees incurred in writing the call in the first place. So if you only have enough shares to qualify for one contract, this strategy may not be for you. But as Alastair Everatt, options dealer at Redmayne Bentley, tells us: "When you have a significant share holding, say, a £10,000 position in Vodafone (equivalent to ten contracts), things get more interesting. A £150 or so monthly cash sum on ten calls more than covers the commission fees in setting up the trade."

An alternative for smaller investors

If you like the idea of trading covered calls, but don't have the funds to pull it off, consider one of the many UK covered call writing funds. The Insight Investment UK Equity Income Booster fund (www.insightinvestment.com, 0845-777 2233) is our top pick. The fund, which takes a covered call approach with 40 or so stocks, has advantages over rival fund, the Schroders Income Maximiser. The initial fee is lower (4% instead of 5.25%) and it targets a higher income (8% instead of 7%). You can reduce the initial fee to 0% by buying via a funds supermarket such as Hargreaves Lansdown (www.h-l.co.uk) and also cut the annual fee to 1.4% from 1.5%.

While most funds suffer in fragile markets, these sorts of funds are built for them. If the markets fall, this fund should fall less. When the markets rise, this fund should rise more. Only when the market goes on a tear, rising hugely, does this fund underperform. And, at MoneyWeek, we believe that the FTSE hugely outperforming is unlikely.

Theo Casey is investment director of the Fleet Street Letter. For more on FSL, see www.investingwithfsl.co.uk .

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