The Pros and Cons of Selling Covered Calls on Dividend Paying Stocks
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This is a guest post from Dividend Growth Investor. Dividendgrowth has been investing in stocks, options, futures, forex and bonds for the past thirteen year. He has been focusing his attention particularly to companies that pay regular dividends to their shareholders since 2003. In his blog he shares his journey on his quest for achieving a sizeable passive income stream that would be realized by investing in dividend paying stocks that have consistently increased their payments over time. He hopes that his blog will serve as an inspiration for his readers and that it would change their financial lives for the better. Dividendgrowth is currently working towards achieving his CPA license, while working at a major US telecom company.
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.
Click to EnlargeThe 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.
13 Comments on this post
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Sami said:
you pointed two risks in covered call writing: one I agree with and the other is irrelevant.
The irrelevant risk is protecting to the downside. in this scenario it does not matter either way because the owner of the stock is exposed to the risk regardless if he wrote an option or not. Actually the writer of the option will fare better as he has reduce his cost base.
February 14th, 2008 at 12:19 pm -
45free.com said:
I generally use the covered call strategy in my “dividend” portfolio by writing calls 6 months out and 20-25% out of the money. While I do not get the same premium for doing so, in the event I am called out at the end of the 6 months, I can generally expect something in the 30% range for a 6 month holding period. If only all my investments returned that much. On the downside, there is generally enough juice in the 6 month call to give me a buck or so worth of downside protection.
February 14th, 2008 at 12:42 pm -
Dividendgrowth said:
Sami,
In my opinion, if I didn’t expect my stock to increase over a certain period of time or I expected it to decline, I wouldn’t sell a covered call. I would sell the stock instead or sell a naked call.
45free,
I don’t think that the risk of missing a huge move in your stocks (above the 25-30% gain that you might get if your options are exercised) is worth the miniscule gain that you obtain for the risk that you are taking. I believe that covered calls are a way for investors to cut their winners and let their losers run.
For example if we look at PEP, it closed @ 71.51 today. Its July 2008 85 call could be sold @ $0.45, which is about 0.60%. So theoretically you could do this strategy twice per year. (since you have a 6 month horizon).
If the stock goes to 90, you miss the last 5 dollars of the gain. You get compensated 45 cents for that. If it stays flat you make the most money - since you collect dividends + options premium.
If it goes down, you are “better off” than a simple buy and hold guy like me by 0.45 cents per contract - trading fees.
My dislike for covered calls generally is that if I expect the stock to go down or sit sideways, I would simply get out of the stock and purchase another one.
In addition you will need to be able to accurately forecast if the volatility of the stock would expand or contract, and how this would affect the price of the options.
This is of course my personal opinion. I could see that statistically you could come out slightly ahead if you can correctly predict that the stock does not increase a lot and that volatility does not increase a lot as well.
Good luck to everyone. The market is so large that there are strategies for all kinds of investors.February 14th, 2008 at 4:15 pm -
Amit Saraf said:
Hi
this is Amit from new delhi India
now just see how high the premiums are here/………..
a finance stock trading at INR 116
strike price 130 sold at 8.3thats like strike price 8-9% away from cmp and premium is nearly 5 % and yes option duration is just 4 weeks i.e. next month only……….
what would be your opinion is such a scenario……………
February 21st, 2008 at 3:30 am -
Bob said:
I’ve been writing covered calls for some time now. Your statement about missing out on upside potential is incorrect. Using simple procedures of rolling an option either out or out and up as well as buying a call back pretty much mitigates that risk. It all depends on the numbers. The same can be said for a stock declining in value. As long as the company does not go bankrupt I will continue to make money for the simple fact of owning the stock.
February 21st, 2008 at 10:04 pm -
Stuart Ritchie said:
I’m using a covered call strategy. I agree with the previous comment about enjoying the upside. You can buy the call option back and sell the stock to take some of the gain. You can also protect the downside by buying a put option valid for several months.
March 2nd, 2008 at 10:13 am -
James Berry said:
Great article
March 9th, 2008 at 3:09 pm -
ernest said:
Hello, thank you very much for your great post. Absolutely your post is very usefull to me. Thanks.
June 7th, 2008 at 4:35 am -
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August 28th, 2008 at 10:11 pm -
CCWriter said:
If you’re interested in covered calls you may want to check out My Covered Call Blog.
October 28th, 2008 at 6:24 am -
CCWriter said:
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October 28th, 2008 at 6:25 am
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