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Assembling a Covered Call Portfolio on Dividend-Paying Stocks

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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.

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. 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. 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.

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 2016 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. 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. 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 this example, options may be 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. 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.

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. The stock price will tend to open 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.

 

This article originally appeared in the June 2014 issue of the AAII Journal and has been edited for length. For an unabridged version visit AAII.com.

 

4 thoughts on “Assembling a Covered Call Portfolio on Dividend-Paying Stocks”

  1. And like most proponents of covered calls seem to miss is that a sharp decrease in the price of the underlying stock means that you will have a large loss, slightly offset by a small premium.

    In other words, you are accepting a significantly limited gain but an unlimited loss. You had better be getting a significantly high premium upfront.

     
  2. In that case, buy to close the option at much lower price and then resale the covered call at different stock price. This is how you minimize the loss without selling the the stock.

     
  3. Pingback: AAII Blog
  4. If the underlying stock price decreases you can always buy the call back to close it out, then sell the underlying stock if you want.

     

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