Writing covered call options to boost yield.

[MrHedgehog]

Hello there,

I am interested to know if anyone has any experience of writing covered call options?

I am starting to look at bumping up the yield on my physical shareholdings (largely HYP/Income based) and writing covered calls against these. And to be clear - I am not quite sure on how to implement this strategy yet, as a retail investor.

I have read up a fair bit in the options area and covered calls in particular and the risks involved but have not had any trading experience yet (and I expect the cost of gaining this experience to be high to begin with).

Thanks in advance for any help/suggestions/recommendations.

Mr Hedgehog.

[Lootman]

The selling of calls against long share positions (named covered calls or buy-write) is common amongst individual investors in the US. The usual advice is to sell calls that are about 10% out of the money. That means that if the shares are called away from you it is at a higher price than it is currently worth. And if they expire worthless then you get to keep the premium received, and can do it again.

People generally claim that you can make on average up to about 1% a month doing this. It's best to sell calls that expire in less than 3 months as that is when time decay is at its fastest, which works in your favour if you are short premium.

There is no real cost to doing this, commissions aside, other than that you give up any upside beyond the strike price of your short call. So it's an opportunity cost. If the price does exceed the strike then you have to decide whether to be called away, or whether to buy back the call at a loss. If you are called away then you can always sell a put option at a strike below the current price, collect more premium, and hope to buy the share back at a lower price. You need margin to do that.

The problem in the UK is that there isn't much liquidity in listed options. Even in the big name shares you will probably only find liquidity in the near months for a few names. Anyone serious about options strategies either uses index options or else uses US shares, where the options are liquid and spreads are narrow.

[Laughton]

I had a go at this a few years ago and did make a very small amount of extra income - the problems I can remember are:

Generally you need to be holding shares in lots of 1,000.

The system works best when the share price stays pretty static or moves up a small amount. Yes, you can write calls well out of the money but then the premium is not worth the hassle (or so I found).

Often the price of the share moved against me so although I had received the option premium it wasn't enough to make up for the loss on the share price. When the share price started going down I was always scared to sell in case it then changed direction and I got called and had to repurchase at a higher price. If a takeover comes along you don't want to be in this situation.

When the share price did move up, even though it wasn't above the strike price, I sometimes found the shares being called - you need to watch out for ex dividend dates - even though the share price is below the strike price this can prompt someone to call your shares thereby gaining the dividend too. Invariably, the share price continued to rise after they'd been called so I received the premium but lost out on the increasing share price. Somehow it always seemed wrong to repurchase a share that I'd had called.

So it needed more time and discipline than I was capable of giving.

I'm sure it can be done - maybe I should have another look at it. I'm wondering if the options market is perhaps not as well supported with the increased use of CFDs?

In case it's of interest - I saw a hedgehog moving her young from nest in the garden to somewhere at the back of our barn last night. Maybe she knows the weather is about to turn colder.

[Lootman]

When the share price did move up, even though it wasn't above the strike price, I sometimes found the shares being called - you need to watch out for ex dividend dates - even though the share price is below the strike price this can prompt someone to call your shares thereby gaining the dividend too.

Presumably then you were trading American options, which can be exercised at any time. As opposed to European options, which only exercise if at or in the money upon expiry:

https://www.investopedia.com/articles/o ... ptions.asp

[Laughton]

Lootman - you may be right but as I said, it was quite a long time ago so I can't be sure. It was always though on UK stocks and I'm sure, though not 100% certain, that there were occasions where the call was excercised before the expiry date.

[Walkeia]

Hi Mr Hedgehog,

In my view - this is the more advanced / high risk side of personal finance and makes the leap from investing to trading. I don't have specific experience on covered call stock strats but have run option strategies against other positions in the day job. My general take away is that selling options long term is a profitable strategy but the loss / opportunity costs profile is uneven and execution pitfalls are high.

We are effectively selling insurance so our payoff will be a series of small wins punctuated by opportunity costs of been called. I can't back-test but my gut thinks the sum of premiums received > than under-performance of been called on the occasions it will happen. However I would echo Laughton's comments - it is easy to get lulled into a false sense of security with this payoff structure and then the psychological impact of the eventual loss or opportunity costs can be difficult to stomach. As always the weakest link in these strategies is the human running it - in terms of been persistent, 100% correct and not missing dividend payment info etc, not deciding they 'fancy it this time' and going uncovered short calls or suffering a loss and then giving up. While less common to see huge rapid equity gains there have been instances throughout history - Japanese QE of the equity market been at the forefront of my mind.

So while I wouldn't put you off - I would want a strong framework to approach it and for it to be for relevant amounts of money as this is going to be hours of your time which has a value.

As an alternative - I use margin from interactive brokers to boost portfolio returns and this could be used to boost income. Again, it adds considerable risk and therefore needs a strong framework - for example - I use limited leverage on a diversified portfolio of investment trusts, REITS and ETFs and don't hold any single names. I wrote a thread on it here which I link if it's of any use.

https://lemonfool.co.uk/viewtopic.php?f ... nd#p219873

thanks