As an income seeker, I’m a big fan of investing in good quality companies that pay hefty dividends. And it turns out that 2018 was a vintage year for this approach.
Link have just released their fourth quarter dividend report for 2018, and it makes for impressive reading. Last year, dividends in the UK rose by 5.1% to reach a headline figure of £99.8bn and the yield on UK shares hit its highest level since March 2009.
That’s great news for income investors. But what if I told you there was a straightforward way to double that yield? So, instead of settling for 5% or 6% you could enjoy double-digit returns.
Welcome to the world of selling covered calls…
Okay, first up, what the heck is a covered call?
A call is an options contract that allows the holder to buy a set number of shares, at a fixed price, within a certain period.
Now, if your heart sank at the word options, don’t worry, I get it. For some reason, they have gained a negative press when they really don’t deserve it.
Used correctly, they actually reduce the risk of owning the already big and boring dividend stocks that I favour.
A covered call simply means that the seller already owns the shares they’ll need if the call holder exercises their option. That eliminates much of the risk.
When you sell a call, the buyer pays you a premium and that’s where the additional income comes from. It’s yours to keep whatever the outcome of the transaction.
So, if you like the idea of receiving dividends twice a year, how would you like to receive option premiums as frequently as once a month?
Let’s have a look at a hypothetical example.
Big Telco Plc
Big Telco Plc is a typical FTSE 100 dividend yielding stock, of the type favoured by income investors. It’s trading at 235p which equates to a well-covered forecast dividend yield of 6.4%.
Assuming you’ve done your research and like the look of Big Telco — you could simply buy the shares, sit back, and enjoy that 6.4% dividend income. Nothing wrong with that.
Or, for a little extra work you could supercharge that income. Here’s how:
Let’s assume that you buy 1,000 shares for a total of £2,350 plus commissions and stamp duty. You could then sell one covered call on those shares.
Why 1,000? Well, a single UK option contract represents 1,000 shares. So that’s the minimum number you need to own in order to sell a call.
There are quite a few different calls available on Big Telco Plc at any one time.
They have different strike prices — the price at which the holder can buy shares from you — and different expiration dates — the amount of time they have to exercise that right.
I won’t get into the nuts and bolts of why you would choose a particular combination at this time — let’s just examine a simple long-term example.
How to supercharge your yield
Looking at my broker’s online platform I can see that you could sell a Big Telco call with a strike price of 250p that expires in December this year, for £140. That’s yours to keep whatever happens.
As the seller of the call, you are now obligated to sell 1,000 shares of Big Telco to the buyer of the call for 250p each, IF they exercise their option on or before the 20th December.
That’s 15p MORE than you paid for them. Why would they do that?
Good question. The buyer of the call is hoping that the shares will shoot up in value by December, and they will be able to buy them from you cheaper than they are trading on the open market.
And for that privilege, they are prepared to pay you £140.
So, what happens next?
Well, if the share price is trading below 250p on the 20th December, the call simply expires. Your obligation is lifted, you keep the £140, and can simply sell another call if you want.
Rinse and repeat. As often as you wish.
You received the £140 for approximately an eleven-month commitment. That’s an annualised yield of 6.6% of the purchase price of Big Telco’s shares.
And of course, you would still collect the dividend on top of that for an overall forecast annualised income of 13%. Of course, you will also be showing an unrealised gain or loss on the shares. That’s not a problem if you intend to hold the shares long-term.
But what happens if the share price rises above 250p by expiration date?
Well, the holder of the call will likely exercise their option and you will be obligated to sell them the 1,000 shares that you own in Big Telco Plc for 250p each.
That’s a grand total of £2,500. So, even with commissions and the original stamp duty you should still clear a hundred and twenty quid profit just on the shares.
And of course, you get to keep the £140 premium the call buyer originally paid, plus any dividends. So, that’s a pretty good double digit return as well.
What’s the catch?
As all good investors know, you don’t get any reward without taking a corresponding risk. So, what is the catch here — where is our risk?
The main risk that you face is from owning the shares in the first place. We all know, that shares can go down in value as well as up.
However, selling the call on the shares actually reduces the risk of simply holding the shares.
You have collected a £140 premium that’s yours to keep whatever happens. That can be offset against any drop in the value of the Big Telco shares.
The other risk is that the share price shoots way up. So, for example, if Big Telco shares jump to 270p each by December, your covered call means that you will be obligated to sell them at 250p each. Not the 270p you could get in the open market.
Of course, you would still make a profit on the shares and get to keep the premium and any dividends — so it’s hardly a bad outcome.
You are giving up some potential future upside in return for some definite income now. I think that’s a pretty good deal. After all, it’s the income game we are in.
If you want to find out more. I recommend a new Income Maximiser covered call trade every month in Income For Life.