Thursday, February 14, 2008

The pros and cons of selling covered calls on dividend paying stocks.

Note: This post of mine has originally appeared on Dividend Guy's Blog as a guest post.

Selling Covered Calls is a strategy in which an investor sells a call option contract while at the same time owning an equivalent number of shares in the underlying stock. It is considered to be one of the safest option strategies in the market. Typically it is performed over a short term period of time, since option contracts always have a finite lifespan. The typical strike price at which call options are sold is normally above the current price at which the stock is trading. Thus, if Pepsi stock is trading at 70, its shareholders could sell a covered call at $75 strike.

The economic incentive for the seller for writing a covered call is that he collects options premium, which increases his income from the stock he owns. With the passage of time, the time value portion of the option's premium generally decreases - a positive effect for an investor with a short option position. In addition to that, the stockholder still owns the stock after he writes a call. So they continue to collect all dividends paid as long as the option is not exercised!
This strategy is most profitable when stocks trade in a range and as a result the call option expires worthless. Thus an investor who can correctly predict that a stock would not experience significant price swings over a certain period in the future, could achieve extraordinary results over time. Investors are also always free to purchase the covered call back from the market at any time if they change their opinion on the direction of the stock price. Even if stock prices decline after a covered call has been written, the investor is still better off, because their losses are smaller due to the options premium collected. If the option expires worthless or is sold profitably and the investor still owns the underlying, they can generate more income by selling more covered calls.
Selling Covered Calls sounds appealing at first, because theoretically one could get two passive income streams from one stock. There are some risks with this strategy though, which might make it less appealing to investors.
First, if the stock price rises above the strike price at which the call was written, one would not be able to participate in any upside gains in the stock, because they are required to sell it to the call buyer to whom the call option was written in the first place. The only scenario in which the investor will keep the stock and the premium is when the stock price does not increase above their strike price. This strategy seems inferior because it assumes that investors could time the market by betting whether or not the stock would be above/below the strike price at expiration. Studies have shown that investors are pretty bad at timing the markets, because the majority always seems to be selling at the bottom and buying at the top. The strategy also seems inferior because by writing covered calls stockholders are limiting their upside potential, while leaving their downside wide open. You are selling your rising stocks and keeping your losers, while earning some income in the process, which in reality is eroding your capital gains. The psychological weak points of this strategy is that most investors always believe that their stocks would be rising over time, so betting against your own portfolio in terms of covered call selling seems counterintuitive. It also does not eliminate the risk of stock ownership - if a stock declines, investors will still suffer losses, although they would be a little lower due to the premium received.
Another negative for owners of dividend stocks who sell covered calls on their holdings, is that there is always the possibility that the call holder might want to capture the stock’s dividend. In that case, the option must be exercised a day before the underlying stock’s ex-dividend date. That’s the only way for the call holder to purchase underlying shares and be eligible for the dividend. In this case, you might not receive notification that the option has been exercised until the ex-dividend date itself.
In conclusion selling covered calls on dividend stocks could theoretically provide an investor with two potential streams of income from one stock if its price does not increase above their strike price – options premium collected and dividends payments received. If the price increases, the call option will be exercised and the investor must sell his stock at a predetermined price. They won’t be able to participate in the stocks upside, unless they buy their stock back, at higher levels. Furthermore the strategy does not protect against declines in prices of the underlying. Just like any strategy involving securities there is always the opportunity for a huge profit if done correctly, or for a huge loss if done incorrectly. Thus an investor will always be better off in the long run if they took those strategies with a grain of salt and do their own due diligence before taking any action, which could impact their finances.

9 comments:

  1. This is a great article. Covered Calls has it's known disadvantages which the author points out very well. But a well disciplined covered call trading strategy can be very profitable and will beat stocks in all but the strongest bull markets. Also, any covered call trader will need some sort of tool to help him make decisions on when to manipulate his positions. A great tool can be downloaded at http://www.coveredcallcalculator.net

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  2. Correct me if I'm wrong, but if someone has a strategy of owning the underlying stock and wants to sell a covered call thus holding the stock and call through expiration, the stock must be trading at a higher price at expiration Friday, not during the time interim period in which he is holding the call,for one to be called out of the stock. If the stock is trading at a price below the strike at expiration Friday, one still keeps his underlying stock and has received the call premium. The point being that the stock price on Expiration Friday determines whether one is called out of his stock...not what the stock trades at during the time period between purchasing the call and up-to expiration Friday....Any comments about this?

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  3. Anonymous,

    It all depends on whether you are selling european or american options.

    Best Regards,

    DGI

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  4. That's true. I've actually called Schwab to try and initiate an exercise on some shares that were pretty deep in the money. My intent was to get the shares sold now so I could have the $ to reinvest, rather than having to wait until the exp. date. Schwab said the was no way to do that, so unless you want to buy back the calls (at a loss), you just have to wait it out. One thing I've done is buy back the calls and then resell them further out, which basically buys me more time and another premium.

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  5. Anonymous is not correct about the exercise of the call. The holder will exercise if the price rises above his strike price, PLUS the call premium (his breakeven point), not just the strike price.

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  6. The thing is you don't know all the different premiums that may have been paid for calls of that precise type. When the options exchange goes to assign open options on expiration day, you could still get assigned the option even if it isn't "in the money" relative to what you were paid for the call.
    If you want to be totally safe against being called out you may want to buy it back before the expiration date.

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  7. another 'option' is to sell a put option if the underlying stock is rising and close to your strike price. The premiums combined lower your real price paid for the stock. Remember, 80% of options expire worthless.

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  8. "One thing I've done is buy back the calls and then resell them further out, which basically buys me more time and another premium."

    Whoever wrote this clearly has no idea what they are doing. When you sell an option you are receiving money and are taking on an obligation to sell if the owner of the option wishes - in the mean time you hold on to your shares. Whether or not early exercise is ever economically smart for the owner is another story, but you can't call your broker and ask that they exercise the ITM calls you SOLD just so you can free up your capital. Furthermore you bought back the options for a loss (why? to free up your money? Why did you sell the options in the first place then?), then you sold more options with further out expirations to "buy" you more time. Here's a tip, you aren't "buying" yourself anything, you are SELLING time. Selling time that you already sold once, then bought back for a loss, and then are selling again. Maybe you should read some more before you trade options...or maybe I should be happy there are people like you in the market giving their money away. As the saying goes, "A fool and his money..."

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  9. One reason I could see to buy back the options is if the stock has dropped significantly in value, and you dont think its going to rebuild, to can buy to close(perhaps for much less than you sold the options for), and sell calls for the same expiration at a lower strike. its possible to get hurt a little bit, especially if the new strike is lower than you originally paid for the stock. Another reason would be if you think the stick is about to completely fall off a cliff, and you want to get out before that happens. Granted buying a put would be an alternative to this.

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