The strategy of yield enhancement, also known as “covered calls”, involves selling out-of-the-money calls against an existing underlying stock holding. Unsurprisingly, given the name “yield enhancement”, the purpose of this call sale is to enhance the return, to enhance the yield on the underlying stock holding.
Investors tend to hold equities for two basic reasons; capital appreciation (the hope that the share price will rise) and/or income (dividends received). The strategy of yield enhancement is best used by investors holding equities primarily for income, investors who are attracted to a stock by the dividends payable upon it. That is not to say that yield enhancement cannot be used by those looking primarily for capital appreciation, just that it is perhaps best used by those investing in shares primarily for income.
Consider the following example. This is a simple, theoretical example for the purposes of illustration. We are stock market investors interested primarily in holding shares for income, for the dividends payable. We have decided to buy shares in company ABC because of the dividend that the share pays and because we believe ABC to be a good company in which to invest.
We buy 1000 ABC shares at 500 (i.e. £5.00). A dividend of 20 (i.e. £0.20) is payable on ABC, the shares going “ex-div” in 4 months' time. Three month ABC stock option prices are shown in Table 31.1. One ABC stock option equates to 1000 ABC shares.
The dividend yield on ABC is ...