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Writing Covered Call Options: a conservative approach

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Most people consider options to be fairly racy, I suppose because of the gearing effect and because of their finite life. However it is possible to use call options to increase the income from your portfolio. That is, by writing covered call options, writing call options against stocks held in your portfolio.

There are a limited number of shares that also appear in the traded option market and they are mostly FTSE100 (UK).

The strategy will work in a market that is not going anywhere (like now?). I will explain by giving you an example.

In your portfolio you are holding 5000 BP shares priced at 474p. You think it is unlikely that the shares will go above 490p in the next three months, and even if they did you wouldnt mind selling them at that level.

Looking at the BP options you want to find one that has a strike of around 490p, expiry October and enough premium to make the deal worthwhile.

The covered call option that is closest to this criteria is the October 500 Call at 9.75p/10.75p

Each contract is for 1000 shares so we need to write (sell to open) 5 contracts which would realise 5x1000x9.75p or £487.50 less costs.

What happens next? Three possible outcomes

• BP shares do not go up to between 500p and 509.75p before the option expiry of 21st October (UK options expire third Friday in the month). The option expires worthless and you keep the £487 and keep your BP shares.
• BP shares rise above £5. The shares will probably be called off you at the strike (£5). That is you MUST sell your 5000 BP at £5 each. You still get to keep the £487.
• The third outcome is really covered by 1., but lets say BP shares start falling and you want to sell them. Although they won't be called you have to remember you still have an open sell contract at £5. You have the choice of buying back the option to cancel (hence the name 'traded' options). The price of the option will be much lower than when you wrote it.

If the outcome is 1. then, of course, you can write another call option which will be the January 2012 expiry.

Writing covered call options: The Risks

None, apart from the above, but there is one possible scenario that would be very annoying. That is if there was a bid for BP (or some other very good news) and the shares shot up to £6. You might kick yourself!

Writing Covered Call Options: More information

http://www.investopedia.com/terms/c/coveredcall.asp
Investopedia.com's definition of writing covered call options.

http://en.wikipedia.org/wiki/Covered_call
Wikipedia's entry on writing covered call options.

http://www.option-trading-guide.com/coveredcalls.html
Another good explanation with examples of writing covered call options.

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