Covered calls can be a useful tool in an income portfolio to lock in a high yield for investors. They involve purchasing a stock while ‘writing’ (selling) an additional call option on the same stock. This technique is useful when a portfolio manager believes that a stock is already priced at a fair value, and would like to generate an additional return in the short term.
For example, an investor may buy a stock at £100 that has a 3% dividend yield. At the same time, he may sell a call with a £110 strike price and an additional ‘yield’ of 2%. This effectively locks the investor in to a 5% yield. If the stock price does exceed £110, the investor will lose out on additional returns, but benefit from all increases up to the strike price. However, it should be noted that, were the price to exceed £110, the dividend yield might be too low for the stock to be held in an income-focused portfolio, and therefore that stock would have to be sold in any event.