Say you own a nice, defensive blue-chip share. In these dire markets, it’s not going to make you rich overnight. But, it’s a decent home for your money and paid a respectable 5% dividend over the last twelve months.
Now that’s worthy, but dull. Instead of waiting another 12 months to collect much the same dividend again, you can put your shares to work for you today and supercharge those returns.
Remember, you are a long-term holder of the shares and simply want to generate some extra cash without extra risk. One way you can do this is to grant somebody else the right to buy those shares from you. But only in return for receiving a worthwhile bundle of cash and at a price that works for you.
This granting of rights has a technical name, known as a “writing an option.” But before you recoil in horror at the word “option,” let me assure you that not all options are complicated or risky. Indeed, on the flip-side of every high-risk option strategy is a low-risk one that just “collects the rent”. And it is precisely this low-risk side of option trading that we can profit from, using a strategy known as covered calls.
Take an extra 37% “yield” AND keep the dividend, too
I’m going to create an example to illustrate… Let’s say you own 1,000 shares in company XYZ, priced in the market at around 2,400p. If bad news comes out, you still want the ability to sell them. On the upside, they are likely to do OK, perhaps making 20% in a good year. But you’re not expecting fireworks in the short-term.
If someone offered you 2,500p for them in a month’s time, we’d grab the money. Maybe we’d buy back into them at some stage down the line. Well, there’s a simple-to-use option strategy that lets you do exactly that. Let me explain…
Two things happen. First, you grant somebody else the right to buy your XYZ shares at 2,500p in one month’s time. This is the “call option”. Second, you pocket the cash that they pay you for this privilege, a sum known as the “premium.”
How much would someone pay for this one-month option? Well, if it expired today the option would be worthless. That’s because, rather than exercise their right to buy your shares at 2,500p (known as the “strike price”), it would be cheaper for them just to buy them in the market at 2,400p. In fact, the market price would need to move up by at least 100p over the next month for the option to be worth anything to the buyer at all.
Well, a realistic market price for this option would actually 75p, and you therefore collect £750 for granting the option over 1,000 shares.
Fast forward one month to expiry day, which is always the third Friday of the month. Let’s say the shares have treaded water and are still at 2,400p. Good news, because the buyer of the option is not going to exercise his right to buy your shares at 2,500p. You get to keep the £750 premium – equivalent to a 3.1% return in just one month. If you can do that each month, you could make 37% over the year.
You’re in control right from the start
The only reason the option is likely to be exercised against you is if, come expiry day, the shares have shot up way beyond 2,500p. If that happens, the option holder might take up his right to buy the shares at 2,500p. If so, your shares are transferred to the option holder, via your broker, and you receive 2,500p per share into your account. You’ve still participated in the first 100p of the upward move from 2,400p, and you get to keep the £750 option premium.
On the downside, suppose the company reported bad news and the shares fell. Your option holder would not want to exercise their option to buy at 2,500p, so you get to keep the shares. And you’d also get to keep the entire £750 premium.
Now if the shares had fallen by less than 75p, you’d make money or break even. Below 2,325p (your 2,400p starting point less the 75p option premium) you’re sitting on a paper loss in the same way as if we held the shares without an option, only £750 less as you’ve had the premium.
So this strategy allows you some limited participation in any upward move in the shares, and some limited protection on the downside too. But above all, it can earn you a decent income on your shares.
3.1% a month might not sound like much. But remember, if you keep holding the shares you can repeat this trade each month, taking in a little “rent” on your shares and boosting the yield to perhaps 30% or 40% each year in addition to the dividend.
Good investing,
Andrew Vaughan
For The Right Side
Editor’s recommendation: Andrew Vaughan is the investment director of The Zurich Club, where this article first appeared in full.
Note: If you’re interested in learning more about using a covered call strategy, talk to one of the specialist brokers who welcome enquiries from private investors. Amongst these are ODL on 020 7903 6150 www.odlmarkets.com; Berkeley Futures on 020 7758 4777 www.bfl.co.uk and Sucden on 020 3207 5680 www.sucden.co.uk.
MARKET NOTES
The plight of the dollar is good for gold
BY SHIVVY ARORA
Gold goes up when the dollar goes down. When the dollar goes up, gold falls.
Two days ago, Bloomberg reported that gold is heading for its best quarter in a year. More and more investors have been buying gold for its safe haven qualities… and as a way to profit from the falling dollar.
And given that the US government seems intent on debasing the dollar with its massive “money printing” programme, that bodes well for the yellow metal.
You can see it in today’s chart. It shows the five year performance of spot gold prices (red line) versus the Dollar Index (blue line). The Dollar Index tracks the currency against six major currencies, including the sterling, euro and Japanese yen. As you can see, broadly speaking, when the dollar declines, gold prices rise, and vice-versa.
The dollar dilemma is the main reason for gold’s popularity
As investor momentum gathers pace against the dollar, we’ll see an even larger move into the safe-haven commodity that is gold.
The Daily Reckoning – Here come the firefighters!
BY BILL BONNER
Paris, France
Thursday, 2 April 2009
We’re playing it straight today. And, as usual, optimistic...
The world is NOT going to hell in a handcart. After a long time spent in the handcart, it is finally getting out and standing on its two feet. Americans are beginning to save again. The Chinese are beginning to look for other places to sell their gadgets and paraphernalia.
Capitalism is doing its work. It’s destroying the mistakes of the Bubble Epoch. It is burning up the errors of the past so it can rebuild for the future.
Yesterday, the Dow rose 152 points. This morning, stocks are soaring in Asia – as the world anticipates further good news. Reports from the economy are terrible; but not as bad as expected, they say.
Layoffs in the US are running at 3 times last year’s rate. And the index of manufacturing activity slipped for the 14th month in a row in March.
Oil is holding around $49. Gold traded around $927 yesterday. And the dollar didn’t move much either – it’s about $1.32 per euro.
But hey... here come the firefighters. What is they’ve got with them? Well, darned... they’ve got another handcart and a ticket to Hell!
Yes, the G20 group is meeting today in London. Mr. and Mrs. Obama have already met the Queen. And the protestors have already met the police.
There are the anarchists, the environmentalists, the Tibetan liberationists, the vegetarians... just about everyone with a gripe is out on the street.
‘Make Love Not Leverage,’ says one poster. Word from our headquarters in London – in the building with the gold balls, across the river from the City – is that protestors are getting out of hand. They’ve attacked police... and smashed up a Royal Bank of Scotland branch office.
“Built on Blood,” they’ve scrawled on the Bank of England. They’ve burned a banker in effigy... and had fist-fights with others. One demonstrator hops around dressed as the Easter Bunny. Others wear masks... intent upon doing mischief.
But what’s the point? These dumbbells are just as confused and hopeless as the G20 big shots they are trying to impress. Both believe the world would be a better place – if people would just listen to them!
Meanwhile, the cost of their mischief is adding up. The protestors don’t really cost very much. What’s a few broken windows? But the G20 costs the world trillions…
Read on…
To read the Daily Reckoning in full, click here.
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