Discover How Covered Calls Work - dummies

By David Stevenson

As a UK investor, imagine that you have 10,000 BP shares worth 470 pence each. You think that they’re unlikely to go up and that they may indeed fall slightly in the near future. However, you still want to hang on to them for the longer term.

To boost your returns in the meantime, you grant ten call option contracts that expire next month: that is, you write out a contract that involves you ‘selling’ an option on those shares. These call options give the buyer the right to buy BP shares at a price of 480 pence. In return, you receive a premium of 15.75 pence per share.

Each call option contract represents 1,000 shares, and so for ten contracts you receive 10,000 x 15.75 pence = £1,575. Subtracting the 15.75 pence premium from today’s share price of 470 pence means that you’re protected from falls down to 454 pence. So 454 pence is your break-even point. After this, you make losses if the price falls any further, albeit slightly offset by the premium income you received.

The options expiry date duly arrives. The share price is below the 480 pence strike price, which means that the option owner is clearly not going to exercise her right to buy, because she can buy BP shares more cheaply in the open market. Therefore you keep your shares, pocket the premium income from the dividend and also collect any dividends sent through over the time.

You’re now free to repeat the operation by writing another set of calls with a new exercise price against your BP shares.

Combined with the dividends you receive on your holding of BP shares, a covered call writing strategy offers a nice way to supplement your income during quiet market times.

If you’re going to write covered calls regularly, understanding the directional bias of the share in question is absolutely essential (that is, you want to know in which direction the stock is likely to move upon the release of anticipated financial reports and current events). You can generate steady returns if you find a share with a relatively stable price and a bias to the upside.