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Barron's explains how to use covered calls to generate income lost when a company cuts its dividend, as many banks and companies have over the last couple of years.

Since Barron's used US Bancorp (NYSE:USB), a stock I own, as its example, I'll use it, too. And I'll comment on the article.

Trading covered calls involves buying 100 or several hundred shares of a stock and selling call options against the stock. The Barron's example talks about how someone with 100,000 shares of stock saw their dividends cut to 20 cents a share, or $20,000 a year, from $1.70 a share, or $170,000 a year.

In my opinion, it would be very difficult to trade 1,000 USB $22.50 strike call options contracts for 40 cents per share, or $40,000, less commissions of about $1,500, as suggested by Barron's. The USB call option market just isn't that liquid. Yes the open interest on that contract is 12,036 contracts, but only 21 contracts traded Friday. And note the bid is 25 cents and the ask is 35 cents, not the 40 cents last price quoted in the Barron's article.

If you're lucky, you'd sell some of the contracts for 30 cents, depending on the stock's price movement and any changes in implied volatility on the day you did the trade.

So, right off the bat, the returns promised by Barron's look a little rich.

The idea is that if you could sell the 1,000 contracts for 40 cents a share every quarter, you'd generate $160,000 annually in premium income, less about $6,000 in commissions, and replace most of the $150,000 in lost dividend income.

Most people, of course trade 100 to 1,000 shares of stock and one to ten call options contracts at a time. And I prefer to write one-month calls on most of my stocks so that I have more control. However, on low-priced, thinly traded stocks and options, options contracts are available ever couple of months or so and you have to trade two to three months out in the options market.

Not so fast. If the stock rises over the next year, you might actually make more money, unless the stock's implied volatility fell. Then you'd make less. And volatility usually falls when the price of a stock rises. Lower volatility means lower premium prices.

Or, if the stock fell, the call options prices could fall, unless the stock price decline was so bad that volatility rose sharply. Sharp stock price increases generally give you increased volatility, which increases the price at which you can sell options.

Barron's notes that there are risks to selling call options on a stock that is trading well below the price at which you bought it.

For example, I bought USB on December 17, 2008. for $25.62 a share.

I immediately sold the USB January 2009 $22.50 strike call options contract (100 shares per contract) for $3.90 a share. That gave me a remarkable 15.22% immediate return and cushion against a drop in the stock price. If the stock dropped below $22.50, I'd keep it and pocket the $3.90 per share premium and do the trade again. If the stock closed above $22.50, the stock would be called at $22.50 per share. I'd lose $3.12 per share on the stock, make $3.90 on the options for a net gain of 78 cents per share. The annualized return on the 30-day trade would be about 185% if the stock fell below $22.50 and was not called. If it closed above the $22.50 strike price, the annualized return would be about 37%. I picked a strike price below the price of the stock because I was afraid USB would drop in price, and it did.

A gallery of daily, weekly and point and figure charts for USB is here.

After the January call option expired, on January 23, I still had the stock and sold another USB February $17.50 strike call option for only 60 cents, a 2.6% return, which reflected the sharp drop in the price of the stock. The increased volatility didn't boost the premium price enough to help me much. At that point, the stock was below the $17.50 strike price. This meant that I had to give myself enough of a cushion so that I wouldn't have to have the stock called if it went up. I generally give myself a 10% to 15% cushion on a depressed stock that I don't want to have called. After deducting the premium I earned on the January option, my effective basis on the stock was down to $21.72 a share, and I didn't want to take a $4.22 per share haircut by having the stock called.

If the stock had gone above the $17.50 strike price on expiration day, I would have bought the option back to keep the stock from being called. This could have cost me anywhere from a penny a share to $2 or $3, which would still have been cheaper than losing $4.22 on the stock if it had been called at $17.50.

On February 23, I still had the stock. My basis or effective cost after earning two months of premium income was $21.12 a share. The stock was down around $11. Bummer. I knew the dividend cut was coming. Another bummer. I didn't anticipate a rally in bank stocks, but I was wary. So I picked a $15 strike price, 36% above where it was trading. I sold the USB March $15 strike call option for only 40 cents a share, less about 3 cents a share in commissions.

Although USB rallied to above $15 for a few days last week, it dropped sharply on Thursday and Friday, closing at $13.42 a share on Friday, when the March options expired, still well below my effective basis of $20.72.

Thus, I still have the stock. It pays a 20 cents a share dividend, down from 42.5 cents. I can sell the April USB April $17.50 strike call option for the current bid price of $1.10 a share, give or take a nickel. I'm thinking bank stocks will correct down over the next month rather than rally. If I were looking for USB to continue its recent rally, I would sell the USB April $20 strike option for about 60 cents a share. At the moment, I'm feeling bearish and don't think that will happen. If the stock is above $17.50 when the option expires on April 20, I'll buy it back rather than let the stock be called and take a loss.

In my opinion, US Bancorp is one of the stronger big banks. Thus, over the next two or three years I expect that I'll be able to generate an annualized return on my investment of 15% to 25% from selling covered calls and collecting the small dividend, depending on what the stock does. And, someday, if the politicians don't screw things up too much, I might actually make a profit on the stock and the company will increase its dividend. USB's point and figure chart shows a bullish price objective of $31, but I'm not counting on it anytime soon.

The numbers above may not add due to commissions. During the three months through Friday's close, this trade has returned 20.6% after commissions in premiums and dividend income. That's an annualized return of about 80% in 93 days. Because the stock is depressed, the returns will be much lower and the annualized return will fall over time because I'll have to sell cheaper, out of the money calls to keep the stock from being called.

I don't expect USB to be another General Motors (NYSE:GM), which I traded last summer and finally sold after it became clear that it may go into bankruptcy or suffer through many years of restructuring under government supervision.

In other words, this strategy didn't work for me on the GM trade.

Caution: Trading covered calls involves a sometimes expensive learning curve. It is risky and not for everyone. You have to do the trading yourself, not through a broker, and you have to work at it. Trading calls is a sideline business for some and a full time business for others. Read some books, blogs and other things before you try this strategy. Start small, trading one contract at a time on three or four stocks.

Links to blogs I read and follow:

  • Covered Calls Advisor. Review the bloggers trades. Read some of the how to articles.
  • My Covered Call Blog. This blogger has an interesting strategy, which continues to evolve. Spend some time reviewing the trades and articles. Also, check out the blog roll, recommended articles and recommended sites in column two.
  • Just Covered Calls Yahoo Group. Great place to ask questions. Just jump in. Join Yahoo.com. Click on groups and search for Just Covered Calls.
  • Click on the "Covered Calls" category link below this post. I've written a few articles about my adventures in covered calls.
  • My book recommendations are here.

Disclosure: Long USB. I don't own GM.

Source: Using Covered Calls to Replace USB Dividend (Barron's)