Covered Call Writing and Options - dummies

By David Stevenson

Many UK hedge-fund managers focus their interest on blue chips: that is, large, liquid stocks in well-known companies. These stocks are hugely attractive to hedge funds because so much is available to buy, sell, borrow and option in nearly endless quantities. In sum, blue chips can be cheaply and quickly traded. Plus, massive outfits such as BP, Exxon, GE and so on are very transparent to the market.

As a result, hundreds of researchers and analysts are watching their every move, estimating every conceivable financial ratio (such as liquidity ratios, activity ratios and debt ratios, that allow comparisons between companies and between different time periods in one company) and closely watching all metrics (indicators, such as real revenue growth, operating expenses and return on assets, that give clues about a company’s current financial health and potential future performance).

When most fund managers have these shares in their portfolios, they sit tight and wait for them to rise in value. But not hedge-fund managers. They can make extra money from stocks sitting in their portfolio by using what’s called a covered call options strategy.

They use their ‘book’ of long assets (shares they own) to write options that can make them extra money (from premiums) for frankly not doing very much at all!

Certainly stock markets can be volatile, scary places at times, but they can also go sideways for long periods. When that happens, making decent returns from just buying and holding shares can be a challenge. Covered call option writing is especially popular among share-based hedge-fund managers operating in relatively sideways-moving markets.

Options come in two basic forms:

  • Call option: The right to buy a share at some point in the future (usually in three to six months).

  • Put option: The right to sell a share in the future.

The idea behind covered call writing is simple — you hold a tight (concentrated and focused) portfolio of maybe 20 shares where you sell a series of in-the-money calls over a rolling three- or six-month period. Although the value of these futures-based options depends on loads of different variables, the crucial idea is whether the option is in-the-money or not.

To explain in-the-money, here’s a practical example. Imagine buying a call option on stock with a strike price (at issue) of £22 while the price of the stock is £25. In this situation the call option is considered to be in-the-money, because the option gives you the right to buy the stock for £22 but you can immediately sell the stock for £25, a gain of £3.

All things being equal, an in-the-money option is more valuable than an out-of-the-money option (its reverse), although the potential for massive gains is much greater with the latter.

These calls effectively limit your upside — if the shares shoot way above the strike price, you have to deliver the underlying shares to the buyer at the agreed upon price.

Yet they do provide you with a stream of options premiums that can be added to the returns from the underlying dividends paid out (assuming that the underlying shares produce a dividend, which you still receive even though you issued the option).

Any investor with a portfolio stuffed full of mainstream, liquid FTSE 100 stocks (particularly those generating a high yield) can use the covered call writing strategy. If you think that markets are unlikely to shoot up in value, you can write calls on your core shares and continue to collect dividends on your underlying investments.

Clearly, this strategy doesn’t work if you sell too many calls in a booming market (you’d be selling away your upside) and it doesn’t save you completely in a vicious bear (falling) market.