Thursday, April 9, 2009

Covered Call Options Strategy for cutting losses on USB

The current bear market has been a heaven for sellers of covered calls. I have mentioned earlier the pros and cons of selling covered calls. Typically I am not a big believer in cutting my profits and lowering my risk reward expectancy in exchange for the options premium. Furthermore I would hate to have a situation where a stock I like is called in and I would have to buy it back at higher levels.

Covered Calls do make sense to me however for a stock that has either not increased its dividend or for stocks in which I have a large paper loss.

Let us look into the first example, where one is sitting at a paper loss and they are willing to decrease it. The severity of the loss that would make you sell covered calls varies from individual to individual based off their risk tolerance. Let’s look at US Bancorp (USB) for example. The stock has been punished this year after losing more than half of its value year to date as investors are losing trust in the US financial system. In addition to that US Bancorp recently cut its dividends by 88%, which was a major red flag and a sell signal for me. If you are still holding on to that position however, waiting for the upturn in the company’s financial situation, selling covered calls against your position might be the only way to generate more income from the stock.

USB was largely trading in a range between $25 and $35 over the past five years, right before the financial crisis started. A dividend growth investor who dollar cost averaged their way into the stock over the past year could have easily bought the stock between $8 and $35/share. Since October 2008 USB shares have lost close to two thirds of their value. Assuming an average cost of $20, this investor would be sitting at a large paper loss at yesterday’s close at 14.45.

Assuming the investor still plans on holding on to the stock, while generating extra income, they could simply decide to sell a covered call with a strike of $20, and an expiration date that would generate some decent income. If called in, the investor would be obligated to sell his stock to the covered call buyer at the strike prie. This being the case, selling a covered call at prices below one’s cost basis would certainly bring losses if shares were called in.

Looking at different expirations for calls on USB stock with a strike price of $20, it seems that the highest prices could be obtained for calls that expire in January 2010 and January 2011. Selling the January 2010 call with a strike at $20, would generate about $210 for every 100 shares held before commission expenses. Selling the January 2011 call with a strike at $20 would generate $310 for every 100 shares held before commissions and other expenses. The first example would increase the yield on cost by almost 10%. The second example would lock in the obligation to sell at $20 by an extra year, but would bring incrementally a higher cash flow.


There have been many stocks which have lost a substantial amounts in short periods of time. If you are looking forward to increasing your income from stocks which have failed to increase their dividends or even worse have cut it, then selling covered calls could be a solution for you. Just like any other stategy however, learn as much as possible about it, before deciding if it is appropriate for you or not.


Full Disclosure: None

This article was included in the the Carnival of Personal Finance #201

Relevant Articles:

- The pros and cons of selling covered calls
- Covered Calls for additional income
- An alternative strategy to covered calls
- Dollar Cost Averaging

2 comments:

  1. Hey DGI - I apologize - I accidentally posted this on your "alternative strategy to covered calls" post - I meant to post here:

    I agree with your general reservation about writing covered calls. Covered calls are great when a stock goes nowhere, but it doesn't protect you against big drops in the stock, and it forces you surrender too much capital appreciation if the stock makes a big move higher.

    But writing covered calls below the original cost basis of your stock can easily backfire if the stock makes a strong rebound, and you're forced to sell at a much lower price than the current market price.

    Most covered call writers trade exclusively for the income potential - stock ownership is incidental. But I advocate covered call writing for long term (dividend) investors as well.

    The idea is to scale things back and write covered calls from a much more conservative perspective. I call it the 1/3 Covered Call strategy - you simply write out of the money calls on only a portion of your holdings.

    This still produces income and it gives you far greater flexibility in case the stock moves significantly higher and you need to roll the calls out and up and not have to worry about being forced to sell your long term holdings.

    If you squeeze out even an extra 5% a year with this strategy, the long term effects will be profound.

    ReplyDelete
  2. I don't have much to say except "Nice post". You integrated the specific example with broader information on the topic nicely.

    Thanks!

    ReplyDelete

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