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Assembling a Covered Call Portfolio on Dividend-Paying Stocks

by Ben Branch

Covered call writing is one of several ways options are traded.

While often done on an ad hoc basis, one can assemble and manage a portfolio of covered call option positions as either a part of a larger portfolio or on a stand-alone basis. Such an approach does require more detailed attention than managing a stock-only portfolio. Nonetheless, systematically managing a portfolio of covered calls has much for me to recommend it.

Covered writing can generate returns in three ways:

  • First, the call writer is paid up front to write the calls, thereby reducing the net cost (stock price – option sale proceeds) of the position;
  • Second, the covered writer earns any dividends paid on the call-covered stock; and
  • Third, the option writer may be able to capture some of the underlying stock’s price appreciation.
  • Taken together, these three income sources can generate rather attractive returns.

For example, as this article is written, stock in AT&T Inc. (T) is selling for about $35.60. Calls with a strike price of $37 having about nine months to run trade for about $0.83. The stock is paying a dividend of $0.46 per quarter, or $1.38 over the life of the nine-month call. A covered call position on AT&T would cost $34.77 ($35.60 – $0.83). If the stock trades at or above the strike price at expiration, the position would generate profits of $1.38 in dividends, $0.83 in call sale proceeds and $2.23 ($37.00 – $34.77) in price appreciation less a small amount for transactions costs. That represents a total of $3.61 ($1.38 + $2.23) on a net investment of $34.77 for 10.38% over the nine-month period. That works out to an annualized return of around 14%. If the stock remained at its current price level (no price appreciation), the return would still be about 8.5%. Even this lower-level return seems attractive compared to current rates on most fixed-income instruments.

Covered writing does incur some risks. One might, for example, write a call on a stock whose price then drops by much more than the sum of the proceeds from the call sale and dividend payments. For example if AT&T’s stock price fell to $27, the loss on the stock position ($35.60 – $27.00 = $8.60) would greatly exceed the sum of the dividends and call sale proceeds ($0.83 + $1.38 = $2.21). Alternatively, the price of the optioned stock could increase substantially once the position is established. In this case, although the call writer may still earn a decent return, significant money would be left on the table, giving the investor a bad case of option writer’s regret. In the above illustration, if AT&T’s stock price rose to $45, one who purchased the stock at $35.60 but did not write a call on it would earn a profit of $9.40 (plus dividends) for a return of more than 30%. Clearly, option writing involves significant risks. But what type of investing offers attractive returns with no risk?

Covered option writers should not be expecting home run–like returns. Rather, their objective should be to earn reasonably attractive and steady returns with a limited amount of risk. To pursue this objective effectively requires attention to detail both when setting up the positions and when monitoring them over time.

How Do Taxes Impact Call Writers?

Taxes also need to be factored into the call writer’s strategy. If a call is written against an existing stock position and ends up being exercised, the gain or loss on the stock represents a capital gain or loss for the investor. If the stock has been held for more than a year, the gain or loss is classified as long-term and taxed at a relatively attractive rate (20% for most investors). If, however, the stock has been held for less than one year, any gain is short-term and taxed at the investor’s marginal rate on ordinary income.

This rate largely depends upon the investor’s total taxable income and is well above 20% for most investors. The marginal rate on ordinary income rises to 39.6% for those in the top tax bracket and even higher for those subject to the Affordable Care Act ACA 3.8% tax on net investment income. That ACA tax applies to married couples with incomes above $250,000 and singles above $200,000.

If a call is written and expires worthless or is covered with an offsetting purchase, the difference between its sale price and the cost of covering (zero if the call expires without being exercised) is classified as a short-term gain or loss regardless of how long the call position was in place. IRS classifies a trade that starts out with a short sale as short-term regardless of whether the sale is said to have preceded the covering purchase. Clearly, the investor would prefer to have income in the form of long-term capital gains rather than taxed as ordinary income. This article’s next installment will discuss how to limit the tax hit on covered call writing.

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Why Use Dividend Stocks

Consider what types of stocks tend to be attractive option writing candidates. Since one of the main sources of return for option writers is the dividend, stocks selected for covered writing should have generous and secure dividend yields. Ideally, the yield will exceed the yields on both the S&P 500 index and 10-year Treasury notes. Not only does a high dividend yield provide a significant part of the desired return, if it is sustainable, the dividends will also tend to support the stock price even when the overall market is under pressure. Only if the company itself has a strong position within its served market and earns a profit rate that comfortably covers the dividend does a generous current dividend rate provide the kind of protection that is likely to limit losses in a declining market. Preferably, the company would not only sport an attractive and sustainable dividend yield but it would also have growth potential. The covered option writer could then seek to capture some of this price appreciation potential by writing calls that are a bit out of the money (strike price above current stock price). A look at analysts’ forecasts and the recent earnings and dividend history would provide some insight into the firm’s growth prospects. In summary, stocks with generous and sustainable dividends that are expected to grow generally represent attractive candidates for a covered option portfolio. Two lists of potentially attractive stocks for covered writing are the 30 stocks making up the Dow Jones industrial average and the stocks in the S&P 500 Dividend Aristocrats index.

Stocks selected for the Dow tend to be mature industry leaders, most of whom pay relatively generous dividends that they tend to be able to maintain. The 10 with the highest yields are called the Dogs of the Dow, most of which would be classified as value stocks. AAII tracks a Dogs of the Dow screen that lists the current Dow dogs, along with their indicated dividend yields, at www.aaii.com/stock-screens/screendata/Dogs.

Dividend aristocrats are stocks that have increased their dividends annually for at least the last 25 years. Clearly such stocks are very likely to have sustainable dividends, based on their past performance. Dividend aristocrats with high yields are reasonable candidates for covered option writing. The components of the 2014 S&P 500 Dividend Aristocrats index and their current yields can be found at: www.topyields.nl/Top-dividend-yields-of-Dividend-Aristocrats.php.

Pricing and Timing

Once attractive candidates for option writing have been identified, the next step is to examine the stock’s option pricing. Options are not written in a vacuum. Some of the factors that make stocks attractive for option writers may also tend to reduce the options’ prices. In particular, stocks with a modest degree of anticipated volatility and high dividend yields tend to have lower call prices than more volatile stocks with little or no dividend yield. Still, if the objective is to produce consistently attractive returns, sticking to less-volatile stocks with decent dividend yields is probably a good idea.

Options can be written at various strike prices and with various lengths to expiration. In order to capture some of the upside from the stock’s potential price appreciation, the option should be written out of the money (strike price above the current stock price). The further the option is out of the money, the greater the potential upside from price appreciation, but the lower the market price of the option. For example, nine-month AT&T calls with strikes of $36, $37 and $38 were selling for $1.33, $0.83 and $0.57 respectively. The more optimistic one is about the stock’s potential price appreciation, the further out of the money the option can be written. Selecting a higher strike price option could result in a significantly greater upside. In the AT&T example, writing calls with a strike of $38 rather than $37 would mean receiving $0.26 ($0.83 – $0.57) less for writing the option. The potential gain from price appreciation would, however, rise by $1.00 ($38 – $37), thereby increasing the potential upside by $0.74 ($1.00 – $0.26). This greater upside may seem attractive. But if the stock price falls or does not rise much, the lower strike option would have produced a better outcome.

The call writer must also decide how long an option to write. In the AT&T case, options were listed with expirations of 1, 2, 3, 6, 9 and 21 months away. As the length of the option’s term increases, its price increases, but generally at a somewhat decreasing rate. For the AT&T options with a strike of $37 and terms of 1, 2, 3, 6, 9 and 21 months, the prices were $0.05, $0.12, $0.22, $0.43, $0.59, $0.83 and $1.57. While the market price increases as the term is lengthened, the rate per month usually declines as length rises. Thus the option writer might be able to earn a somewhat higher return per period by writing shorter-term options. Such an approach has some significant disadvantages, however. Specifically, the more times one must buy and sell options and stock, the greater the transactions costs and the greater the likelihood of adverse tax results. Moreover, one can get whipsawed by short-term price fluctuations. So option writers should generally set up their initial covered call positions with relatively long-term options.

Writing one-year options is a pretty good place to start. That way if the stock reaches the strike price and is exercised, the position will give rise to long-term capital gains, which are taxed at a favorable rate. Moreover, writing one-year options gives the situation time to evolve favorably. That is, the stock has a reasonable opportunity to rise and the investor can hold the stock long enough to earn several dividend payments.

Key Calculations to Make

Before actually assembling a covered position, the investor should make several calculations.

First, compute the return if the stock is at the same price at option expiration as it was when purchased. In this case the gain would be equal to the sum of the dividends to be received plus the proceeds from the option sale. The return would be this gain divided by the net cost of the position (cost of the stock less the proceeds from the option sale). For example, if the stock had a 3.5% dividend yield and the call was sold for a price equal to 6% of the stock’s price, the position would produce a total return of about 9.5%. An attractive covered position should generate a decent return in this circumstance. In the AT&T example, this was 8.5%.

Second, calculate how far the stock’s price would have to fall before the position would show a loss. This is the same percentage number as the gain on the transaction if the stock price did not change. That is, the sum of the dividends and proceeds from the option sale. Note that if the stock falls further, the position will show a loss. In the AT&T example, the stock would have to fall by $2.22 to $33.38 (a decline of about 6.2%) before the position would show a loss (assuming the expected dividends are in fact paid). The price of $33.39 represents the breakeven point. As long as the stock’s price stays above this level, the position will show a profit.

Third, compute the maximum gain on the position: the sum of the dividends and option proceeds plus the difference between the option’s strike price and the cost of the stock. For a nine-month call, the annual return is this sum divided by the cost of the position, which has already been calculated above. In the AT&T example, the maximum gain on the position would be 12.77% (17% annualized). In more aggressive call writing using options with a strike of $38.00, the potential gain would be 14.0% (18.7% annualized). The covered option position should only be established if the investor finds each of these calculated numbers attractive.

Who Gets the Dividend?

When a company declares a dividend, it establishes the day that determines who receives that dividend, referred to as the record date. Those who are on record as owning the stock on that date will be paid the dividend even if they sell their shares before the checks are sent out. Because settlement of trades takes three business days, you must have purchased the stock three or more days prior to the record date in order to receive the dividend. The first day after the last day for owning the stock and being paid the dividend is called the ex-dividend date.

The stock’s price will typically fall on its ex-dividend date by about the amount of the dividend. In the case of AT&T, with a dividend of $0.46 per quarter, the stock price will tend to open about $0.46 lower on the ex-dividend date than the price at which it closed the day before.

Those who trade options need to keep an eye on ex-dividend dates of stocks on which they have written options. If the call owner chooses to exercise the option just before the ex-dividend date, they will capture the dividend. If they let it pass, the covered writer will receive it.

Outcomes

In a portfolio approach to covered writing, the objective would be a set of outcomes that were not only generally positive, but provided a relatively steady and attractive return.

In periods when the market rises rapidly, returns from the strategy, while attractive, might lag the market and leave a significant amount of the long stock positions’ upside on the table.

On the other hand, in a declining market, the income generated by option writing coupled with the type of solid dividend-paying stocks selected for the portfolio would generally cushion the impact of the weak market such that the overall portfolio return would be significantly above the market averages.

Finally, in a directionless market, the strategy should generally outperform the market averages, as the proceeds from option writing would add to the returns on the long stock positions without leaving much money on the table from those few stocks that did well in a market moving sideways.

Ben Branch is a professor of finance at the Isenberg School of Management at the University of Massachusetts, Amherst, and is an expert in bankruptcy investing, bankruptcy management, and valuing distressed assets.


Discussion

VL from CA posted 4 months ago:

I used to run this strategy with SPY. To make it simple, say if I own 100 shares of SPY and write one contract of covered call. I'll collect a premium of the call. However, each time SPY paid a dividend, the brokerage firm deducted the dividend for the call (i.e. 100 shares of SPY) from my account. I asked the brokerage firm why I should pay the dividend for the call position, the customer service did not have a clue why. But I figured it might be caused by the price drop due to the dividend paying.

Anyway, my expericence is that if you write a covered call, you won't collect any dividend before the expiration date of the call.

Was I ripped off by the borkerage firm ?


William Newport from HI posted 4 months ago:

HiVL

The only time I have had a dividend deducted is when I shorted SPY as a hedge against a market correction. If you own shares of SPY you should be paid the dividend each quarter on the covered position. The short call option should generate no dividend activity.


VL from CA posted 4 months ago:

OK, I think the following discussion explains what happened to my covered call positions:
"If you are short call options in a stock or an Exchange Traded Product (ETP) like SPY or IWM you need to be aware of ex-dividend dates. If your calls are in the money, even barely, your options may be assigned right before the security goes ex-dividend—and then you may have a problem ..." http://sixfigureinvesting.com/2013/12/short-calls-options-assigned-ex-dividend-dates/

VL


William Myers from MN posted 4 months ago:

While I agree with this strategy and have used it successfully for several years, the example using AT&T (T) has a basic error. The basis in the stock at $35.60 is reduced by the $0.83 call option proceeds, for a basis of $34.77. However, in the total proceeds at the end of the nine-month period, the author includes the $0.83 call proceeds AGAIN in getting to his gain of $4.44 ($2.23 + 0.83 + $1.38). It should actually be $2.23 + $1.38 = $3.61.


GRE from VA posted 4 months ago:

Seems to me that if one could generate a 17% annualized return, year in and year out, one would not care about missing out on rapidly rising markets. Am I missing something?


Dave Samuels from CA posted 4 months ago:

ON covered calls, I generally recommend going 1-3 months out & 1 strike out of the money. Example-if your stock is currently trading at $39, sells calls going 1-3 months out at $40.00. Why? The further out in time you go, in general options pricing is less favorable due to wider bid/ask spreads. This is caused by lower volume which can make these trades difficult to fill at favorable prices on the short calls.

Return results of course will vary with performance of your selected stock. If the market goes up significantly as in 2013, you would have been better off owning the stock outright (of course, hindsight is so easy to judge). A big drop in your stock can result in some significant losses. Do check your x dates as if you are ITM (in the money) chances are you will be called away as the buyer of your call is looking to capture the dividend on the stock. I recommend picking a dividend paying stock & selling calls against it every month 1 strike out of the money. If you are called away, congratulations! You made $$ on the rise in the stock + your option premium. Just buy the stock and repeat the process. You will get a feel of the options market and how the short call reacts to your stock going up & down.


John O'Connell from TX posted 4 months ago:

GRE, that's only the successful trades that generate 17% (in this example). If you can always pick the stocks that are going to go up, you should be buying calls not selling them :) I try to sell covered calls on stocks I want to hold, but only when the charts tell me that a short-term drop in price is likely. When I think it's going to go up, short term, I stay naked long stock.


John O'Connell from TX posted 4 months ago:

VL, yes if the option is in the money right before the ex-dividend date, and will expire that same month, you are very likely to be exercised. I always look at the ex-dividend date compared to the option expiration date, and try to avoid that situation. Sell the next month out instead. The dividend capture people likely want to get their dividend right away, not wait a month for it.


John O'Connell from TX posted 4 months ago:

When you trade options, you have to know about "the Greeks": delta, gamma, vega, and theta. Selling covered calls, theta is key: it tells how fast the option price decays as time passes. Theta for out of the money calls is highest close to expiration. It is often recommended to sell the call with 30-45 days to expiration, so theta can work harder in your favor. (It's still income generation, but with more of a trading flavor to it.) I like to sell an OTM call with 30 days left for 1% of the stock price (12% annual return if not exercised, more if it is), and then buy it back for $.05 (or $.01) up to a week before expiration, capturing almost all the premium (in less time), and avoiding the risk of a sudden big jump in price that puts it in the money, when you have very little left to gain by letting it expire worthless. And then you can sell the next month's option on the same position.


Elmer Stahlecker from Kansas posted 4 months ago:

I'm rather new at options and don't understand all the techniques. As I understand in the example for AT&T , one would buy 100 shares of AT&T stock at 35.60 per share ($3560.00) then sell a 37 call expiring in 9 months.
If AT&T stock goes above $37, then the option would be exercised. (Does this always happen?)
If the stock price is below my strike price at expiration, then I may keep the 100 shares of stock and receive the premium on the option plus any dividends. And I can choose another strike price and expiration date and sell another call.
My risk would be if AT&T's stock dropped and I would have a paper loss on the stock.
What level of trading do I need for the broker to accept this trade?


Larry Sealy from AL posted 4 months ago:

Elmer,

Covered calls are not considered risky. Approval from the broker shouldn't be a problem. Selling naked options requires much more experience to get approval nowadays.

As for "Does this always happen?" - mostly. I have had some stocks not called (or a partial exercise) if the stock is barely in the money. For individual investors that own the options, the broker will automatically exercise in the money options unless the customer instructs otherwise.


Rodman Johnson from TX posted 4 months ago:

Commissions have been neglected. Of course commissions vary from broker to broker and the first call is the highest with subsequent calls at a lower price. I find it best to buy at least 200 shares and in multiples of 100 as each call is for 100 shares. I also have a spreadsheet with calculations to show the annualized return for both the stock called and not called at the Monday following the expiration date.


Allen Evans from ME posted 4 months ago:

William Myers comment is correct. The author counts the option sale proceeds twice in his AT&T example. The example profit is actually $3.61. The 9 month return is 3.61/35.60 = 10.14%. Annualized that is 10.14% x 12/9 = 13.52%.

Also, generally the advice is to sell calls with about a month to go, and to understand the greeks.

The CBOE website offers an excellent education series on options, including covered calls. It's free and thorough.


Dave Gilmer from WA posted 3 months ago:

I have been doing these strategies for a few years now, but in a rising market, selling covered calls on your income generation is not always the best bet, because you will eventually get stopped out of your income producers and then need to buy them back at a higher price (less yield.) Sure you might make a little gain, but the long term outlook is not that good.

A better strategy is once one of your good stocks is sold due to an exercised option, you should go short a put on this stock, at a price that you would want to own it. There is usually more premium in a put and thus you can afford to not worry about the lost dividend. There is also no need to wait for the option to expire. When I double my money, I usually just buy it back and roll up or out to the next option. If the market turns on you and you own the stock, well you are back to covered calls, but this happens less often in an up-trending market.

Being retired, I don't do this year in and year out, because you have to watch your options.

I also don't recommend this for someone who is new to options or doesn't understand all the "ins and outs," however for me it adds somewhere between 25% to 50% to the already 7% dividend income from my 20 dividend stocks.


John Atta from NJ posted 3 months ago:

Ben Branch,

Thank you for an informative article. Please clarity some points. Your first (ATT) example demonstrates a cost basis of $34.77 which includes the income of the call sale. Therefore one's profit at the exercise price of $37 would be $3.61 ($37 - 34.77 + $1.38 (dividend). This represents a simple yield of 10.38% and an annualized yield of 13.84. The call income seems to be considered twice in this example.

Also, in your explanation of breakeven point, dividend + call proceeds = $2.21 not $2.23.

Thank you.


John Attanasio from NJ posted 3 months ago:

I see others have picked up on these anomalies. Thanks.

Also,
For those that are practicing or considering this strategy, there shouldn't be any regrets about limiting your profit when the stock price exceeds strike. This is an income strategy NOT a growth strategy.

Consider it a good day should you have your stock called away at expiry when the price exceeds strike.

PS Nothing prevents you from taking a new position in the stock or rolling the calls prior to expiry when they are ITM (stock price > call price).


John Attanasio from NJ posted 3 months ago:

I see others have picked up on these anomalies. Thanks.

Also,
For those that are practicing or considering this strategy, there shouldn't be any regrets about limiting your profit when the stock price exceeds strike. This is an income strategy NOT a growth strategy.

Consider it a good day should you have your stock called away at expiry when the price exceeds strike.

PS Nothing prevents you from taking a new position in the stock or rolling the calls prior to expiry when they are ITM (stock price > call price).


John Atta from NJ posted 3 months ago:

John (TX): Spot on analysis and insight.
Dave (WA): A good strategy that I employ from time to time even for non-div stocks. I'm considering MKX puts for Monday trade.

PS
Please recommend some of your 7% dividend stocks!


John Atta from NJ posted 3 months ago:

Oops, sorry that's BKS (Barnes/Noble) puts @ 20 strike.


Herman Sabath from CA posted 3 months ago:

One month I very successfully did covered calls on some stocks that had good news and the calls for one month duration were 3% or more. I felt great! Then I got greedy and saw the HOT biotec stocks were going at 4 to 6 % for one month duration. I jumped in ignoring the extreme volatility and very high P/E and got clobbered as the biotec started to crash.

Now my criteria for selecting a stock is low volatility and a conservative P/E. Just sold a SAFM 08/16/2014 100.00 Call at 3.90 and Bot the stock at 98.40 The P/E for the stock is 12. $3.90/98.4 = 3.96 %. It's not easy to find these stocks. MU is another stock that provides over 4% for the 8/22/2014 calls.


Dennis Black from Texas posted 3 months ago:

I have been selling covered options for about 3 years now. So far, I have averaged about 17% gains using the technique. The first year I went very carefully and conservatively. And the market has generally been bullish in this time frame. The discussion in this thread has used Blue Chip dividend stocks for underlying stocks. I use the technique with several good underlying stocks like T, VZ, LLY, MRK, XOM and a few others. As I have gained more and more experience with covered options, I have been using more speculative stocks. Granted, there is more risk and I have had some losers but I have also had some very big winners including more speculative stocks. This past year, I had 26% gain. When I started using this technique with more speculative stock, I moved into In The Money options. One can receive really good downside protection on those stocks because the premiums are so high. As the market approached 17,000, I have chose more and more of these speculative stocks and picked up 20-25% downside protection. My goal is to make 20% per year on my portfolio. The last 18 months I have been able to beat that goal.


Nord from CA posted 2 months ago:

With regard to William's comment, the author's comment in paragraph 4, sentence 5 is somewhat awkward, but the return numbers reflected in sentence 6 reflect the same $3.61 gain that is contained in William's comment.


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