Psst! There is a little-used way that you, as a shareholder of large UK companies, can double or even treble the income you receive from dividends. And with no extra risk.
You can get a handsome fee, often 2-4% of the current share price, for granting someone else the right to buy your shares sometime in the next few months, at a higher price than they currently stand. You shouldn’t do it on your whole portfolio of course, but selling away part of the performance potential of your shares is perfect for those times when you don’t see much upside.
The way to make this extra income is through traded options. Specifically the selling — or writing as it is known in the market — of call options on shares you already hold.
Options have a reputation as risky and dangerous, but they don’t have to be. In fact, they can be quite the reverse. Writing a call option, as long as you own the underlying share, can be looked on as insurance against shares failing to rise. You are actually hedging the risk you take when you buy the shares.
In bear markets, a pound in the hand is worth two in the bush
When you sell a call option you give the buyer the right, but not the obligation, to buy shares from you at a fixed price, any time before the contract expires. If you sell a Vodafone September 100p call, for example, the buyer has the right to buy 1,000 shares in the telecoms firm for 100p from you any time before the expiry date in September. Calls and puts (put options give the owner the right to sell shares) are traded on the London International Financial Futures Exchange (LIFFE), and one contract usually represents 1,000 shares.
Expiry dates are set at three-month intervals. The price at which an option can be exercised is known as the strike price, and there will be several both above and below the current share price. In Vodafone’s case, strike prices are available at 10p intervals from 50p right up to 260p, where the shares used to trade. The vast majority of trading volume occurs in strike prices close to the current share price because these are seen as less risky choices. Options are traded in just the largest companies, usually FTSE 100 members or those recently in the index, as well as on the indices themselves.
LIFFE options in individual companies use what is called ‘American-style exercise’ which just means that they can be exercised at any time before the expiry date. Index options are available in both American- and European-style series, the latter meaning exercise only takes place on the actual expiry date.
The art of selling call options is to pick your moment. If you are seriously expecting a stock to double, don’t sell a call as this gives someone else the right to your shares. Similarly, if you are really worried that a stock may plunge, you should sell the shares rather than sell a call option, which forces you to keep holding the shares.
Selling a call option without actually holding the shares is a very risky business indeed. If the buyer of your call option wants to exercise their right to buy the shares, you will have to go out and buy those shares on the open market in order to complete the deal. The buyer will only exercise their option if the shares are trading at a higher price on the open market.
So you can see the potential problem: you buy the shares at a high price on the open market, only to sell them at a lower price to fulfil your side of the bargain. This is why we recommend you only sell covered call options, options on shares you already own.
Here’s how writing call options works
Say you own 1,000 shares in tobacco firm BAT. With the price currently at 618p you could — at the time of writing — sell a 650p October ‘call’ on LIFFE for 28p per share. The contract gives whoever buys the call option the right to buy the shares from you for 650p each, anytime until the October 16th expiry date. They won’t do it, of course, unless the share price rises and they can then sell those shares in the market for more than 650p.
There are three scenarios to consider. If BAT’s share price bounces up above 650p in the next three months, the call option may be exercised on you. This means whoever bought your call option, will exercise their right to buy your shares from you at the agreed price. However, the share price will have to exceed 678p — the 650p strike price plus the 28p per share you’ve already made from selling the call option — for you to be worse off than if you hadn’t sold an option. In absolute terms you still have a profit of 9.7%.
The second scenario is that BAT shares fall, in which case you are better off having sold the call option. The option will expire worthless, as your buyer won’t want to buy shares from you when they can buy them cheaper on the open market. If the shares do fall, the 28p extra income you earned from selling the call option offsets the first 28p of any fall in the underlying share price. Of course, if things go seriously wrong for BAT, as a shareholder you are in a similar fix in either case.
You can make money from sideways movements
If BAT shares go sideways over the next three months or rise but do not reach 650p, the option will expire worthless. This is because your buyers will not want to exercise their right to buy your shares at the higher price of 650p. Perfect. For every 1,000 BAT shares, you pocket £280, almost a year’s dividends, and an extra return of almost 4.5% in just three months. If all goes well you could repeat the process twice or even three times a year.
So why isn’t everyone doing this? Quite simply many investors would rather sit naked in a tank of cobras than touch an option, but their risky reputation conceals a more complex truth. Options strategies can be constructed for any risk profile, and selling covered calls (call options on shares you already own) is one of the least risky. Indeed, by making returns more predictable, it actually lowers the risks of share ownership.
Prices are carried on LIFFE’s website (www.liffe.com), and daily price summaries appear in The Financial Times. LIFFE also lists approved brokers. Many advisory brokers outside this list also offer traded options services. Though commissions vary, expect to pay roughly £20-£40 on a call option that brings in £250, plus a bid-offer spread of at least 2p per share. Before they will let you sell a call, most brokers insist that you own the full 1,000 shares in the underlying company, as an odd number like 989 clearly makes life more complicated. They may even move the shares to a collateral account to ensure you don’t forget about your liability and sell them.
Choosing your option
Just a casual glance at the Financial Times option summary will show the large variation in prices for call options, with some apparently worth just a few pence per share and others worth several pounds. A large part of this variation is of course related to the value of the underlying share.
A call that gives the right to buy a £10 share at 10% above its current price until September, is bound to be more expensive than one giving the same rights over a share trading at 50p. Before selling a call, you need to calculate the return on capital. To do this you divide the premium you would receive by the current share price. For example, at the time of writing you can get over 180p per share for an Astra Zeneca 2100p call expiring in October. But a Standard Chartered 650p call expiring on the same day is worth 51p, and offers a similar return.
The second issue is time. The longer an option has to run to expiry, the more time there is for the share price to achieve the objective that its owner requires, and the higher its value.
A July 100p call on a share trading at 100p is currently unlikely to be worth more than 2p or 3p because it has so few days to run. But a March 2003 call could easily be worth up to 25p.
As the seller of a call, your predictive powers become more stretched looking this far into the future. If you are going to hold a share for nine months, you will tend to earn a greater premium by selling a three-month call three times over that period, than by selling one nine-month call. And you will also get greater flexibility to adjust to a more lucrative strike price, should one appear.
The final variable is volatility. When the prices of BSkyB and Lloyds TSB shares were roughly similar at 560p, the option premiums for an identical 600p September call were very different. Predictible, profitable Lloyds TSB typically offers less than two thirds the return for an option seller than the satellite TV firm because its shares tend to move less dramatically. The higher return offered for selling the BSkyB call reflects a greater chance, based on past movements, that the option will be exercised against you.
The beauty of options is their flexibility
The examples given have been of selling calls at strike prices above the current share price, to lock in a profit in case of upwards movement. However, if your view is more bearish you can sell, for a substantial income, calls with strike prices below the current share price. This income can hedge the effect of even large share price falls, but carries a commensurately higher risk of exercise should the stock in question rebound. If you hope for higher prices but fear lower ones, then you can easily sell calls against half your holdings in a particular stock, steering you an income-earning compromise between the market’s uncertainties.
For those new to options, an advisory broker can be helpful. This summer has already proved fruitful for call option sellers. The top of the next substantial bear market rally looks set to be another. It is income you cannot afford to miss.
NICK LOUTH
