Lately, I have written a few articles involving strategies to boost yield in high-paying stocks by selling LEAPS against a long position, like these examples about AT&T (T) and Transocean (RIG). Each time, I was flooded with comments and questions to the tune of "Why not just sell short-term calls each month and make more income?" Well, for a few reasons.
Case Study: Microsoft
I chose Microsoft (MSFT) to use for an example of this type of strategy because it just now has become a much more interesting income play. Just this morning (Tuesday), the company announced a $40 billion stock buyback and a nice dividend hike to $0.28 per quarter. At the current share price ($33.02 as of this writing), this translates to a 3.4% annual yield. The buyback should continue to add a steady stream of increased value to shares, and definitely helps to give the share price an upside bias going forward.
I also think that the acquisition of Nokia (NOK) could prove much more lucrative than the market seems to believe. Nokia's newest phone, the Lumia 1020, is starting to seem like a true threat to the iPhone and Samsung's Galaxy phones with its amazingly high-resolution camera and Windows Phone 8 operating system. There is quite a buzz surrounding the new Nokia, and sales should be fairly strong.
So, as of now, an investment in Microsoft by itself yields 3.4% annually and is trading well below its 52-week high of $36.43, which makes it a good candidate for my favorite income strategy. Let's take a quick look at how a LEAPS strategy could help boost your returns while protecting your portfolio to the downside at the same time.
Commissions, strike prices, and the chance of having your options called
First, in order to make any significant income by selling short-term calls, you would need to choose strike prices that are much closer to the current share price, which increases your chances of being "called out" of your position. For example, let's take a look at Microsoft, which is one of the most widely held dividend paying stocks in the market. At the current share price of $33.02 as of this writing, selling January 2015 $37 calls for $1.82 would be the strategy I would recommend. This would provide you with 12.1% of upside protection, meaning that getting your shares called away would produce this much of a gain. When you add in the income made by selling the call, you are sitting on a healthy 17.6% return, and that's not including any dividends you are paid along the way.
As far as the short-term options are concerned, a $37 call expiring in one month only trades for about $6.00 per contract, so the commissions alone would make this trade impractical. In order to make it worthwhile, commission-wise, you would have to lower the strike price of the calls you sell. For example, the October $34 calls are currently selling for $0.48, which would mean a 1.5% yield in a month. Commission would take a significant bite out of this, depending on the size of your trade, and there is a high probability of getting your shares called, as Microsoft tends to fluctuate by about $2 in each direction in any given month. I don't think it's worth it to have your income stocks called away in pursuit of a 1.5% gain, do you? However, I'll gladly give up my shares for the nearly 18% return mentioned above!
Taxes: a bigger deal than you may think
One of the most common misconceptions I have heard from my readers is that any options trade is automatically taxed as short-term capital gains (i.e., ordinary income). As long as the trade (short option) is open for at least a year and a day, profits are taxed at the lower long-term capital gains rate. For a single filer making between $36,250 and $87,850 annually, which is about the median bracket, ordinary income is taxed at 25%. However, long-term capital gains are taxed at just 15% from the 25% all the way up to the 35% tax bracket. For my college student readers who may be just starting out, there is zero capital gains tax if you're in the 15% bracket or below (taxable income of less than $36,250 per year).
Using our Microsoft example again, let's say that you buy 500 shares of Microsoft at $33.02 for an initial cost of $16,510, and that you sell 5 contracts of the aforementioned January 2015 $37 calls against your position, for an income of $910. When holding until expiration, you'll collect 5 (now higher) quarterly dividend payments along the way, for a total of $700. Qualified dividends (which these are), by the way, are taxed at the lower 15% rate as well.
The goal of this trade is for Microsoft to close at or above $37 at expiration. If this happens, your shares would be called for $18,500, you would collect the dividends along the way, and you keep the income from the calls you sold. All in all, your trade is now worth $20,110, for a pre-tax gain of 21.8%. If you are in the 33% tax bracket, the entire $3,600 profit is taxed at the 15% capital gains rate, giving you an after-tax return of 18.5%. If, somehow, you were able to replicate this income with short-term calls, your tax liability on the options increases by $163.80, dropping your total return by over 1%. Bear in mind that you will have also paid 16 times the commissions along the way (16 months till expiration) and will likely have gotten called out at least once or twice, causing you to have to repurchase your shares. All of the sudden, the entire profit becomes a series of short-term gains and hikes your tax bill even more.
While short-term covered call selling is one way to go, it is not the best choice for dividend-yielding stocks that you would prefer to keep for the long term. Selling LEAPS against positions has several benefits, and the particular strike of the options could be adjusted up even further, reducing the chance of getting called away even more. Hopefully this sheds some light on why I am constantly recommending income strategies involving LEAPS, and has answered some of the questions of their benefit. Stocks like Microsoft are especially good candidates, as I look for companies with rising dividends and substantial planned buybacks, as it increased the upside bias of the share price over the long run.