Dividend Investing With Covered Calls: Why Stop at Yield?

Includes: ANH, EVEP, LINEQ, NLY, T, VZ
by: Marty Chilberg

I'm surprised at the percentage of yield based investment strategies that don't incorporate covered calls. I understand many investors have favorite dividend stocks and enroll in reinvestment plans. If that's the case, this approach isn't for you because a percentage of the time you'll be forced to sell the stock. But if investors have the time to do some research and the inclination to use options to effectively increase yield, they could double or even triple their annual income.

For anyone unfamiliar with covered calls, it's not particularly complicated. The strategy I try to utilize goes as follows:

  1. Complete due diligence on targets and eventually buy shares in a company with good fundamentals and yield.
  2. Look at the historical trading pattern of the stock around ex-dividend dates. This is especially important for large yield plays like MLPs (Linn Energy (LINE), EV Energy Partners (EVEP)) or mortgage REITs (Annaly Capital Management (NLY), Anworth Mortgage Asset (ANH)) or even wireless carriers (Verizon (NYSE:VZ), AT&T (NYSE:T)).
  3. Pick an expiration date (3rd week of every month) that is after the ex-dividend date.
  4. Pick a strike price above the current price ("out of the money"). Usually for me it's 1 or 2 ticks (next dollar) above the current price.
  5. Place the contract order based upon the trading pattern of the stock. If it's flat, no time like the present. If it's rising, consider waiting until it approaches a resistance point. If it's dropping, why did I buy it?

I generally write contracts using a limit order for a little over the current spread (bid/ask).

What are the ramifications of selling the call? It's not that complicated. First what you have sold is the right but not requirement for a buyer to buy your shares at the strike price until the expiration date. If that sounds complicated, it's really not so I'll provide a quick example using Verizon. Caution: I'm picking an example that highlights the positive attributes of this approach.

Let's say that I decided that VZ was a stock I wanted to buy. So around the 1st of September I bought it at $30. The stock was climbing nicely and the next ex-dividend date wasn't until October 6th so I decided to watch and wait. On September 23rd the stock at $32.20 looked a little tired so I decided to write the call. Yield stocks typically rally around the ex-date and then pull back so I decided to sell the October calls with a strike price of $33.

So let's say I sold one call for 100 shares for 55 cents per share. If you look at the chart you'll see that this stock continued to rally past $33 and as we approach October 5th the stock closed at $33.57. The buyer of my call exercised their option and bought my shares for $33.00 per share. Adding back the call premium I received $33.55. Not a bad trade but I walk away a little disappointed that I sold the right to the dividend of $.48. I shouldn't have. Look what happened next.

On October 6th the stock rolled over trading ex-dividend and closed yesterday at $32.21. So instead of holding a stock worth $32.21 and waiting for the dividend check of $.48, I received $33.55 and have been able to reinvest the proceeds for over a week and if I want to I can even buy back VZ now and pocket the difference. I look at it a little like trading a range.

Does it always work out this way? Of course not. There are times I have a stock called that I didn't want to lose and regretted it as I watched it continue to rise in value and pay out premium dividends. That comes with the territory. However investing to me is like sports... you don't win them all but you try to have an average that puts you ahead in the long run.

Statistically around 75% of all calls written expire worthless. That's a pretty nice advantage to have on your side which means that 75% of the time you keep the stock, keep the dividend and keep the call premium. Not bad. The remaining 25% of the time you'll sell the stock and lose the dividend but as my above example shows, even in those cases you'll be better off some of the time. And the rest? Congrats to the buyer of the call. They knew the stock better than me. I'll get them next time.

You should be aware that call options erode over time. So the farther out you look, the higher the price of the option. For investors not interested in spending a lot of time trading options and researching new yield stocks to replace those that get called, you should consider expirations that are out further. This increases your premium but will normally reduce the annualized yield a little because annually you'll write fewer contracts per investment. After calls are priced, they will erode in value as you get closer and closer to the expiration date.

Disclosure: Author long LINE, EVEP, NLY, ANH, and VZ

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