• Trading Strategies
  • 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.

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    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 over 2 years 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 over 2 years 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 over 2 years 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 over 2 years 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 over 2 years 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 over 2 years 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 over 2 years 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 over 2 years 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 over 2 years 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 over 2 years 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 over 2 years 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 over 2 years 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 over 2 years 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 over 2 years 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 over 2 years 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 over 2 years 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 over 2 years 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 over 2 years 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 over 2 years ago:

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


    Herman Sabath from CA posted over 2 years 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 over 2 years 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 over 2 years 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.


    Larry K. from Ohio posted about 1 year ago:

    This strategy works fantastically in a rising market. In one that's going down, it's not going to work so well, as the price of the underlying may decline more than the sum of the option premium and captured dividend.


    Paul G from Florida posted about 1 year ago:

    If the price of the underlying stock dips below the strike price of the option is the stock automatically called away? Can you buy the option back prior to exercising?


    Charles Rotblut from IL posted about 1 year ago:

    Paul,

    The stock is only called away if the option holder chooses to exercise his call option. It is possible that you will be able to close your option position before the stock is called, but doing so is not guaranteed. The outcome depends on how quickly you act relative to how quickly the option holder acts prior to expiration.

    -Charles


    Randy from MA posted 8 months ago:

    Going back to early post. The author is correct. Your profit is the $.83 + $2.23 + dividend. If you don't include the premium how would you ever make money as in or at the money.?


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