Thursday, February 14, 2008

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

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.

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