The following is a guest post from Gavin at Options Trading IQ.
Investing for dividends is one of the best strategies you can follow as a long term investor, and there is an abundance of fantastic advice here on The Dividend Ninja. In the never ending search for yield, is there more that we can be doing to increase our returns? Absolutely! Covered calls are a great tool to add to any dividend investors’ arsenal.
What is an Option?
An option is a contract that gives the buyer the right, but not the obligation, to buy or sell 100 shares of a stock at a specific price (strike price) on or before a certain date (expiration date). That sentence may sound a little confusing and you may have to read it a few times before it sinks in.
An option, just like a stock or bond, is a security. It is also a binding contract with strictly defined terms and properties. Options are traded on an exchange, just like a stock. There are two types of options, call options and put options. For the purposes of this article, we will only look at call options.
A call option gives the holder the right to buy a stock at a certain price within a specific period of time. Buyers of calls hope that the stock will increase substantially before the option expires. But what about those who sell call options? Buyers of call options have the right to buy; therefore sellers of call options have an obligation to sell.
Phrased another way, if you are a buyer of a call option, you can choose to exercise your right and buy the underlying stock, but you don’t have to. For the seller of a call option, it’s a different story; they have an obligation to sell their shares.
The below diagram (Fig. 1) shows the profit and loss potential for a Long Call option. A Long Call is a strategy where an investor buys a call option with the view that the stock will appreciate in price. In this example the investor is buying 1 call option with a $40 strike price and a $2 premium. As 1 call option represents 100 shares, the total premium (amount) paid by the investor is $200 ($2 x 100 shares). This is also the maximum amount that the investor can lose. Even if the stock goes to zero, all they will lose is $200.
What is a Covered Call?
A covered call is when an investor sells a call option over a stock that they own, i.e. the call option is “covered” rather than being “naked” (selling options naked is a stupendously bad idea unless you are VERY experienced). Investopedia’s explanation of a naked option is:
Naked trading is considered very risky since losses can be significant. An options trader could sell, for example, call options with a strike price of $10. If the stock’s price rises to $20 or $30 on good news, and the option is naked (the seller does not own the underlying stock). He or she would be required to buy the specified number of shares at the current price, and sell them to the option buyer for the $10, resulting in a significant loss.
So, naked options are a bad idea, but covered calls are much less risky as the investor is “covered” by the shares that they own. By selling a call option, the stock owner receives a payment from the option buyer, known as a “premium”. This premium is yours to keep as a covered call seller, not matter what happens to the underlying stock. This premium effectively increases the yield that you receive from dividends. In return for receiving this premium, the stock owner is foregoing the right to any capital appreciation above the strike price. So, this is the trade off, you forgo future capital appreciation in return for receiving a cash payment today.
The below payoff diagram (Fig. 2) of a covered call compared to a long stock position shows a couple of key differences. Firstly, the breakeven price is lower on a covered call at $29 rather than $30 and secondly gains are capped above $32. As mentioned earlier, with covered calls, you are foregoing the price rise above a certain point in return for receiving the premium income from selling the call option.
When to Sell Covered Calls
Covered calls are a great strategy for stocks that the investor expects to remain steady or appreciate slightly. For this reason it is best to choose relatively stable stocks with a low beta (a measure of how much a stock moves in relation to the overall market). High flying tech stocks or a recent IPO would not be good candidates.
A good time to sell a covered call would be on a stock that you own that has had a recent run up in price. At this point you might think that the stock is unlikely to appreciate further in the short-term and you would be happy to sell it if it did rise slightly. For example, say you bought a stock for $40 and within 6 months it had appreciated to $50. You would be happy to sell it for $55, so you could sell a 3 month call option with a $55 strike price and receive $1 in premium for doing so. In three months, if the stock is above $55, your shares will be “called away” (i.e. sold) at $55. Your total return in this example would be $16 ($15 in stock appreciation and $1 in option premium).
Hopefully you can see that the covered call strategy will outperform a pure stock position in flat, falling or slightly rising market environments. In strong bull markets, covered calls will underperform as the upside gains of stock ownership are capped. For this reason, it is not a good idea to start selling covered calls at the start of a strong bull market (e.g. April 2009).
Now that we know a little bit about covered calls, let’s look at how dividend investors can apply it to their portfolios. Dividend investors can “supercharge” their dividend income by selling covered calls.
It’s sometimes easier to understand using a real life example. For this strategy I like to use large multinational corporations with low volatility. That means stocks in the consumer staples and utilities sectors are good candidates. Some of my favorites are KO and JNJ.
KO is currently trading at $75.50 and is paying roughly $2.04 per year in dividends for a yield of 2.70%. Not bad, but let’s see how much extra yield we can gain by selling covered calls. Here’s an example of how you could set up a covered call:
Buy 100 KO shares @ $75.50 = $7,550
Sell 1 KO November 16th $77.50 call @ $1.98 = $198
Total outlay: $7,352 ($7,550 less $198)
Breakeven Price: $73.52 ($75.50 less $1.98)
Maximum Gain: $398 ($200 from stock appreciation and $198 option premium)
Maximum Gain percentage: 5.41% or 12.75% p.a.
You can see from the payoff diagram below (Fig. 3) that the maximum gain on this trade is $398 which is the difference between the purchase price ($75.50) and the strike price ($77.50) plus the premium received ($198).
In addition to this, you still receive dividends during the life of this trade, so you would still receive the $51 dividend due in September. And the best part of all? If KO finishes below $77.50 when the call option expires, you get to repeat the process all over again by selling another call option.
What if KO finishes above $77.50
If KO is above $77.50 at expiry, it’s not such a bad thing as it means you’ve made your maximum profit. In this case, your 100 shares of KO will be “called away” and you will sell them for $77.50 no matter how far above $77.50 KO is currently trading. You can then choose to start the process over again, if you think KO is still a worthy covered call candidate. Or, you can look around for another stock that might make for a good covered call trade.
So there you have a brief introduction into the world of options and more specifically covered calls. Covered calls are the most popular option trading strategy and can significantly increase the income you receive from your stock portfolio. Thanks for reading, and please feel free to share this article on Twitter or Facebook if you found it useful.
Readers, what’s your take? Do you used Covered Calls in your dividend investing strategy?
Options Trading IQ is a site dedicated to teaching traders of all levels how to trade options.