Why Income and Dividend Investors Should Consider a Covered Call Strategy

by: Hedgephone

With the stock markets close to making new three year highs, many investors looking for income and capital preservation should consider the covered call strategy on a portion of their equity holdings. The CBOE S&P 500 Buywrite Index (BXM) has meaningfully outperformed a long only investment in the SPY index fund for a substantial period of time, although such a strategy has underperformed recently, given the rapid upward trajectory of stocks and commodities over the past year.

The covered call strategy essentially involves selling near month call options against your stock holdings to collect the option premium you receive from the buyer of the call option. Most investors who are very optimistic in their stock holdings do not want to sacrifice any upside for a deeper margin of safety and income stream that a covered call strategy provides. However, the math behind the covered call strategy shows that significant alpha and reduced volatility can be achieved from writing calls against existing stocks.

A strategy such as this does not generate great returns in vertical bull markets, but covered call investing markedly outperforms long only investing in market sell offs and in bear markets. In fact, over the past five years, the worst loss an investor in ^BXM faced was 25% or so versus the 45% draw down in the SPY.

While many stocks are cheap enough and of sufficient quality to own without any protection, IRA investors who don’t have to worry about tax complications that arise from straddles can sell calls against the stocks they already own and can reap meaningful rewards from this strategy. The ^BXM has gained attention in recent years as investors look for ways to reduce risk.

Here are some interesting yields for investors who already own these stocks in their portfolios:

MSFT: $28.75 -- Microsoft $28 Feb. 19, 2011 calls yield $.44 for a gain of 1.5% by expiration to covered call sellers. The maximum gain for the next 19 days is achieved if MSFT is above $28 on Feb. 19 for a 2.4% return. While you lose out on the upside above $28.44, if MSFT drops you own the stock, but with a $.44 lower cost basis than your original purchase price. MSFT has a forward P/E of 10 and an EV/EBITDA of 6.86.

RIMM: $60.15 – Research in Motion Feb. 19, 2011 $62.5 calls yield $.95 per contract, or a gain of 1.58% by expiration. The maximum gain occurs if RIMM is trading above $62.50 at expiration for a 5.5% return between now and expiration. If RIMM is trading below the current price, you will lower your cost basis by $.95 on your stock position. RIMM has a forward P/E of 9.1 and an EV/EBITDA multiple of 5.44.

CSTR: $41.49 – Coinstar’s Feb. $42.50 calls yield $1.51 making the Buywrite strategy particularly attractive in this name. If CSTR trades above $42.50 by February 19th, investors can earn a 6% return over 15 trading days. If CSTR stays at $41.49 at expiration, investors earn a 3.6% return from collecting the call option premium. CSTR trades for 14.66X forward earnings and an EV/EBITDA multiple of 6.35.

MCD: $73.28 – McDonald's March 18, 2011 $75 calls yield $.75 cents per contract, which is not an exciting return by itself; however, with the safety and moat of MCD, investors can up their yearly dividend substantially from selling calls against this stock, making it an ideal investment for retirees. MCD trades for 13X forward earnings and has embraced the health food market with oatmeal, smoothies, salads, fruit, and coffee. If the stock hits the mid $60s I will be adding to a small position.

OTCPK:CCME: $20.86 – China MediaExpress Holdings is an interesting company which places billboards on buses throughout China. Call options here are particularly rich, as the Feb $21 calls can be sold for $1.5 per contract, or a yield of 7.1% in just 15 trading days – that’s a return of roughly .5% PER DAY between now and Feb. 19, 2011. This is an incredibly volatile stock, but with a forward P/E of 6.8 and an EV/EBITDA of 4.3, investors should consider this lucrative options opportunity when looking to add to their Chinese exposure.

NE: $37.34 – Noble Corporation has had its share of troubles this year but the company is well managed with strong historical growth and sports a relatively low price to book value ratio. Noble $38 Feb. 19 calls can be sold for $.72 cents per contract, or a yield of roughly 2% between now and expiration. With a 9X forward earnings multiple and an EV/EBITDA of 8.1, Noble seems like a good value at current prices.

CVX: $93.37 – Although CVX missed revenues by 4% in the last quarter, the company trades for just $8.9X forward earnings and an EV/EBITDA of 5, making it a bargain if oil prices continue higher and the company can expand reserves. The Feb $95 calls look attractive to me at $.84 cents per contract, or a yield of .9% in the next three weeks.

In conclusion, selling out of the money call options on your stock holdings can lower volatility and add downside protection to your portfolio. 401K investors can fully benefit from this income stream, but most investors need to be cognizant of the tax implications of a covered call investment strategy. All in all, the outperformance of covered calls in bear markets should be thoroughly researched by retirees who seek income and principal protection into their golden years. Low interest rates make covered calls attractive in comparison to bond investing. Given the risks for municipalities and for treasuries going forward, covered calls seem to make a lot more sense than many other investment alternatives.

Disclosure: I am long MCD, OTCPK:CCME, CVX, RIMM, MSFT, NE.