Writing covered British options as a way to increase income

by | Jul 30, 2000 | Archives

Conservative British Income Increasing Idea

Dear International Friend,

Merri and I are headed south taking 100 investors to Ecuador. We'll be gone 10 days. During this time I have asked several eClub advisors to send you current economic ideas and more information about themselves.

In this first message club advisor Richard Radcliffe at Anglo Irish Bank Isle of Man gives insights about writing covered British options as a way to increase income with very low risk.

Dear Gary

I write in response to your enquiry regarding options and their uses in overall portfolio management. At this office we have been using written calls and puts to either protect the downside or enhance the return.

1. Writing Calls

This is quite straightforward, where the client holds the stock and receives a premium for entering into an obligation to sell it if it goes above a particular price. Let's say it's GE which is currently about $53 and you can write a call to the end of December at a strike price of say $56.375 and receive a premium of about $3.50 or 6.6% over 6 months. If the stock remains under $56.375 in December, you keep the premium and can do the same again then. As you already hold the stock you are entitled to any dividends etc until you are exercised against. If GE is over $56.375 in December you have to deliver the stock, but you will have made an additional capital gain of $56.375- 53 = $3.375 (ie approximately 6.36%), so your total return would be over 12% in 6 months. Finally if GE is not called, it will have to be lower than $53 less option premium of $3.50 = $49.50 before you are losing money. Also you can write a call again to recover the position. Remember you can trade the option which I can elaborate on if you so wish.

2. Writing Puts

Here the client retains his funds on interest earning deposit, but enters into an obligation to buy the stock if it falls to a certain price. Let's say it's $50 and he agrees to buy it if it drops to $46 and he receives $3.50 option money for undertaking this commitment. If the stock remains above $46, he keeps the premium and can rewrite (as with calls). If it drops below $46, he has to buy it, but remember the actual cost to him is $46-$3.50 = $42.50 against the previous price of $50. Only if exercised against, ie. it goes below $46, does the client have to find any actual cash, and until then it's on deposit. We would only sell ie write “puts” where we would be happy to take up the stock if we had to and we always ensure the client has the funds to meet the obligation if it arises ie. we are not “naked” with unlimited liability.

At the present time we are writing calls on many stocks in the portfolios, but with the markets very nervous and future trends unclear, we are holding substantial cash balances and writing “puts”.

The following is a good example of even where it goes wrong you can still look towards a profitable conclusion.

Example: Sage – a UK accounting services provider

In early May, the stock was over 660p and looked quite firm. We sold a put ie. agreed to buy the stock if it fell to 600p before end of June and received 27p for it ie. we would be getting 27p without putting up any cash, at that stage.

The markets fell and Sage fell with them and so by the exercise date in June it was below 600 at 550p and we had to take the stock up. However our cost was actually 600p – 27p = 573p, which meant we were still paying 23p more than the then price. What we did next was this. Since we now owned the stock, we were in a position to write a covered call and we chose to write one at 550p ie. we agreed to sell it up to December at 550p and received 102p for this. If it is below 550p in December we will write another call, and each time our cost price goes down. However in this first case 573p less 102p to 471p against current 550p.

If it goes over 550p we have to deliver it to the market, but remember it's now only cost us 471p, so should still be in profit.

For interested E-Club members I can provide the relative supporting graphs and Bloomberg option printouts to support these figures.

Bear in mind, in this case it was not the intention to take up the stock, merely to pick up the “put” premium. However even though the market went against us and we were forced to take up the stock, rather than sell it again into a loss, by applying then a written covered call I will be surprised if we don't show a satisfactory profit at the end of the year.

The point is even though Sage has fallen from over 600p to 550p, we can still show a likely good profit by using different written option strategies. As mentioned earlier you can also trade the actual options, but that's another story I can send later if you wish.

Send any questions or comments to my email address (see foot of this page)