We're delighted to present an article written by Greg Robinson, SIPPclub Member and the Editor of "Income For Life", a monthly publication aimed at helping you turn a modest lump sum into a regular, sustainable income.
It’s my mission to navigate you towards strategies that are suitable for you and that will help you make decent income from the markets in today’s world of low returns.
Greg Robinson, Editor, Income For Life
A Quick Word From Brian Bennis, SIPPclub's CEO
In May 2018, Greg and I were discussing peer-to-peer investing within a SIPP. He dropped into conversation he's the editor of a monthly financial magazine, the publisher of which is Agora Financial UK. I told him that from 2006, our IFA firm used to provide advice for the clients of a number of its publications. A small world, indeed!
During our conversation, he mentioned 'covered calls'. I thought it would be of interest to you, so let me pass you over to Greg to explain all about it.
One Of My Favourite SIPP Investment Strategies Is To Invest In UK Blue-Chip Dividend Stocks
There is a great selection of world-class companies to invest in, and at the moment many of them have dividend yields north of 5 per cent or even 6 per cent.
You can buy the shares in your SIPP, then sit back and simply watch your dividends roll in twice — or four times — a year. Of course, there’s always the risk that the dividend will be cut, but there are many examples of companies that have paid an increasing dividend year after year.
For me, that makes a pretty compelling basis for a SIPP investment.
But what if I told you there was a straightforward way to double that yield? So, instead of settling for 5 per cent or 6 per cent you could enjoy double-digit returns.
I presume that is something you would be interested in?
Well, welcome to the world of covered calls.
To show you how you can make the most of your dividend stocks, I’ll have to get a little bit technical I’m afraid.
But please bear with me. Once you’ve applied this technique a couple of times, you’ll see it’s no more complicated than buying the shares in the first place.
Selling Covered Calls
The technique we are going to discuss is called selling covered calls.
Okay, let’s start by breaking down the jargon.
A CALL is simply an options contract that allows the holder to buy a set number of shares, at a fixed price, within a certain period of time.
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 stocks that make up most folk’s pension funds. I’ll explain why shortly.
Calls are traded on an exchange and bought and sold through a broker in a very similar way to shares. So, if you have ever bought some shares, you already have half the skills you need.
A COVERED call simply means that the call is backed by the actual shares required if the holder decides to exercise it. And don’t worry, I’ll explain exercise in the example below.
The key point is that this is a very safe investment.
And SELLING a covered call means that we are going to sell a call on shares that we already own. The shares we own cover the call.
When we sell a call, the buyer pays us a PREMIUM that is ours to keep whatever the outcome of the transaction. That’s where the additional income comes from.
If you like the idea of receiving dividends twice or four times a year, how would you like to receive option premiums as frequently as once a month?
Okay, enough of the definitions – let’s have a look at a hypothetical example to help clarify the process.
Case Study: Big Bank Plc
Big Bank Plc is a typical FTSE 100 dividend yielding stock, of the type favoured by income investors. It has operations in the UK and abroad so it’s geographically diversified and largely plods along year in, year out.
It doesn’t get much more exciting than that, eh?
Only kidding, it’s a pretty boring company really and that’s great. The less there is to get excited about the less stressful the share ownership is likely to be.
First things first. Let’s have a look at Big Bank’s dividend credentials.
Let’s say Big Bank is trading at 630p and that equates to a forecast dividend yield of 5.2 per cent. That’s pretty good, but are they reliable payers?
Well, a quick check online tells me that the dividend is forecast to be covered approximately 1.9x times by their earnings — that’s good — and they have paid that dividend for the last 20 years. It did take a chop after the financial crisis but its generally been moving in the right direction ever since.
So, assuming that you have done your research and have decided that you like the look of Big Bank Plc — you can buy the shares, sit back, relax and enjoy your 5.2 per cent — and hopefully growing — dividend income. Nothing wrong with that.
Or, for a little extra work we could super-charge that income. Here’s how.
Remember I said that Big Bank is trading at 630p per share.
Let’s assume that you buy 1,000 shares for a total of £6,300 plus commissions and stamp duty of half a per cent. That would allow you to sell one Big Bank covered call on those shares.
Why 1,000? Well, a single UK option contract represents 1,000 of the underlying shares. So that’s the minimum number you need to own for this strategy to work.
There are quite a few different calls available on Big Bank 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 typical example.
How To Supercharge Your Yield
Looking at my broker’s online platform I can see that you could sell a Big Bank call with a strike price of 650p and an expiration date of March 15th next year, for £250.
Whoa, what does all that mean?
It simply means that you could sell one call contract on Big Bank and pocket £250. That’s yours to keep whatever happens.
As a seller of the call you are now obligated to sell 1,000 shares of Big Bank to the buyer of the call for 650p each IF they exercise their option on or before the 15th March.
Exercising a call option simply means that the owner of the call instructs their broker to buy the shares at the agreed strike price.
The key point here is that they can choose to buy your shares for 650p each — that’s 20p 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 the 15th March. They will then 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 £250.
So, What Happens Next?
Well, if the share price is trading below 650p on the 15th March, the call simply expires.
Your obligation is removed, you keep the £250 and can simply sell another call.
Rinse and repeat. As often as you wish.
You received the £250 for approximately a nine-month commitment. That’s an annualised yield of 5.3 per cent of the current price of Big Bank’s shares.
Oh, and of course you would still collect the dividend four times a year on top of that for an overall annualised income of 10.5 per cent.
That’s a pretty good result.
But What If Someone Exercises The Call...
So far, I’ve looked at the hypothetical situation whereby the share price never rises above the strike price.
Of course, sometimes you will sell a call and the share price will rise above the strike price by the expiration date.
What happens then?
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 Bank Plc.
In our example, we have assumed that you paid 630p per share. If we add in the commissions and stamp duty that means you are out of pocket by approximately £6,340.
If the holder of the call exercises their option, you will be obligated to sell them 1,000 shares at 650p each. That’s a grand total of £6,500. So, even with commissions you should still clear a hundred and fifty quid profit just on the shares.
And of course, you still get to keep the £250 premium the call buyer originally paid you plus any dividends that have been paid.
So, that’s a pretty good result 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.
As an income-oriented investor, the share price is a lot less relevant than the yield, but we all know it doesn’t feel great when shares go down in value.
However, selling the call on the shares actually reduces the risk of simply holding the shares.
You have collected a £250 premium that’s yours to keep whatever happens. That can be offset against any drop in the value of the Big Bank shares.
Your risk from selling the option is that the buyer will exercise it and you will have to sell them your shares.
But, as we have seen, as long as we choose a strike price that is higher than the price we have paid for the shares we will never be forced to sell the shares at a loss.
The key point here is that the call is covered by the shares that we already own. You must never sell an uncovered call — that is much riskier. Luckily, most brokers will not allow new option traders to do this, so it’s not an issue.
The other risk is that the share price may shoot way up. So, for example, if Big Bank shares jump to 680p each by March next year, your covered call means that you will be obligated to sell them at 650p each. Not the 680p you could get in the open market.
Of course, you would still make a small profit on the shares and get to keep the premium and dividends, but you get the idea.
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 SIPP investors are in.
Hopefully, this walk through has piqued your interest in covered calls. I think it is a great strategy to run in — or outside of — a SIPP and would recommend you investigate further.
Special Offer From One SIPPclub Member To Another
I edit a monthly newsletter called Income For Life in which we regularly discuss many different income strategies including property investing, peer-to-peer lending, income funds, dividend stocks, covered calls and anything else that takes our fancy. Many of which can be included in SIPPs.
And each month, I present a specifically researched covered call opportunity with the exact details of which shares to buy and calls to sell. We call it the Income Maximiser.
If you would be interested in subscribing, I’ve negotiated a discount with my publisher for SIPPclub Members.
A 61.85 PER CENT DISCOUNT OFF THE NORMAL PRICE.
I believe it’s great value.
And you also get a free 42-page guide describing the strategy in detail and recommending suitable brokers to use.
And it’s all backed by a cast-iron money back guarantee — so you’ve really got nothing to lose by giving us a try.
If you are interested, please hit the blue button below.
The content of this promotion is not intended as investment advice. Options trading may not be suitable for all investors. Ensure you fully understand the risks involved and never risk more than you can afford to lose. All gains are gross unless stated otherwise, and bid/offer spreads, commissions, fees and other charges can reduce returns from investments. There is no guarantee that dividends will be paid.
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