AT&T: How to Use Covered Call Options to Enhance Returns

| About: AT&T Inc. (T)

I recently wrote an article that identified 10 stocks whose attractive yields made them candidates for IRA investments. This follow-on piece will examine how using options can enhance the yields on these investment choices. Specifically, I will focus on writing covered calls against newly purchased shares. (The term "covered call" simply means that one owns the underlying stock.)

For those less familiar with options, the definition of a few terms might prove useful. Specifically, since this article will be addressing covered call options, the terms will only address call options:

Call Option: A vehicle that gives the buyer the right, but not the obligation, to purchase the underlying shares from the seller (or writer) of the option agreement at the strike price on or before the expiration date.

Option contract: An agreement between the buyer and the seller, typically representing 100 shares of a single company. It specifies the expiration date and a strike price. (There are times when stock splits, mergers or spin-offs will necessitate adjustments to the size and nature of the shares represented by one contract. This is true for some of the options of Verizon (NYSE:VZ) which have a cash and Frontier Communications (NYSE:FTR) component.)

Strike price: The price at which the buyer of the call option has the right to purchase the shares from the seller or "writer" of the option contract.

Expiration date: The last day that the buyer of the option contract can exercise the right to purchase the specified shares.

Option premium: The dollar amount received by the seller of the Contract. This is expressed as a per share amount.

Options with a strike price below the current share price are often referred to as "In the Money" while those with a strike price above the current share price are considered "Out of the Money."

One of the stocks mentioned in the article was AT&T (NYSE:T). It was chosen because of its attractive current dividend yield of 5.6%. Would you be willing to limit the potential capital appreciation - or even take a small capital loss - for an additional four percentage points of total return? Here are selected examples of how using In and Out of the Money options could substantially boost your returns. Friday's closing prices were used and the impact of commissions were ignored (for options, the closing bid price was used since options are traded less frequently).

The stock closed at $30.77. Call options with a $32 strike price and a January 21, 2013 expiration date closed at $1.64 bid. The quarterly dividend of $0.43 is typically paid on August 1, November 1, February 1, and May1, and can be expected to be paid to shareholders of record during the first week of the prior month. If the share price remains at or below its current price, the seller of the option could be expected to collect seven dividends and the premium for a total of (7 x $0.43) + $1.64 = $4.65. This is a return of 15.1% in 581 days, or an approximate annual return of about 9.5%. [Note that if the stock is called away at any point prior to expiration, the average yield would be higher because (a) the capital gain of $1.23 ($32.00 - $30.77 = $1.23) would be realized and (b) the remaining dividend payments that are yielding 5.6% actually reduce the average return.]

A second alternative could be to sell an In the Money call option with a $30 strike price and the same January 21, 2013 expiration date. Should the share price remain above the $30 strike price, it is almost certain that the shares would be called away before the expiration date. In this example, the seller of the option contract would collect the option premium of $2.49 and can anticipate a capital loss of $0.77 ($30.77 purchase price minus $30 strike price) at some point prior to expiration, assuming the share price remains above $30. The net of the option premium less the capital loss is $1.72, which is equal to one full year of the AT&T current dividend payments. Assuming all dividends are paid, the seller of the option could be expected to collect up to seven dividends and the premium, less the capital loss, for a total of (7 x $0.43) + $1.72 = $4.73. This is a return of 15.4% in 581 days, or an approximate annual return of 9.6%. [Note that, as above, if the stock is called away at any point prior to expiration, the average yield would be higher because the remaining dividend payments that are yielding 5.6% actually reduce the average return. There is a reasonably high probability that the stock would be called prior to the seventh dividend, although that was not modeled into this example.]

Trading In the Money call options provide a bit more protection and a bit greater yield in a down market. In the above examples, your net capital outlay is $28.28 per share vs. $29.13 for the Out of the Money call option. In addition, if the share price drops below the $30 strike price your stock would not be called.

Many of the other stocks on the list are excellent candidates for this type of strategy. Option premiums and dividend yields for FirstEnergy (NYSE:FE) and Verizon are similar to AT&T. B & G Foods (NYSE:BGS) and Merck & Co. (NYSE:MRK) offer lower dividend yields, but may still be attractive to some investors. On the other hand, Suburban Propane (NYSE:SPH) and Invesco Mortgage Capital, Inc.'s (NYSE:IVR) option premiums might be considered too small relative to the size of the dividend to be attractive candidates (IVR went ex-dividend on Friday by $0.97).

So, is this too good to be true? That all depends on the mindset of the investor, and there are certain risks. If you absolutely want to hold on to the stock, the strategy may not be right for you. There is an excellent chance that your shares will be called, and you may not be able to find a similar investment opportunity with the same dividend yield, dividend growth and safety profile. You can always close the call position by buying back the option contract, but if the underlying stock price has increased significantly, the cost may be far more than you are willing to pay.

That's perhaps the biggest risk - the potential loss of the capital appreciation on the stock. You can be sure the buyer of your option contract expects the price to be significantly higher by the expiration date. That buyer wouldn't be paying you the 5-10% premium if she/he didn't think there was an opportunity to make a nice profit, and the option buyer makes money when the price of the underlying shares rises.

So if you like the idea of a yield between 9 and 10%, you might want to take a closer look at writing calls against some of your positions. And if the idea of all the tax implications of capital gains on the option and capital gains and losses on the stock seems daunting, you can avoid that hassle by conducting the transactions in your IRA.

Final technical notes on the yield and annual yield calculations. There was no attempt to factor in interest rate compounding. If that were done, the annual yield of approximately 9.5% referenced in the AT&T example would have resulted in a lower Annual Percentage Yield (or APY). On the other hand, no attempt was made to take into account that the flow of cash back to the investor takes place at various points in time before the end of the investment period. In fact, the option premium reduces the net cash outlay at the beginning of the investment period and each of the quarterly dividend payments occur before the end of the investment period. Incorporating the actual timing of these discrete events would increase the APY above the 9.5% in the AT&T example. On balance, these adjustments would not materially (less than 0.3%) impact the calculations.

Disclosure: I am long T, FTR, VZ, IVR, FE, MRK, BGS.

Additional disclosure: I am also long SPH may open or close call positions against any of my positions at any time.