Covered Calls: Mandatory Option Trading Techniques for the Income Investor

Includes: DNDN, ERF, MOO, PM, SDRL
by: Michael J. Ray

When it comes to the world of investing one of the most overlooked tools of the trade is the use of options. Retail investors tend to shy away, or sometimes just outright avoid, the practice of using or learning option trading techniques. Often times I find misinformation, a complete lack of understanding and some vague horror story is more than enough to keep the retail income investor at bay out of fear. This is actually a tragedy as the use of options in one’s investment portfolio is a critical component to success.

To put it in layman’s terms: Consider building and running an investment portfolio as like building and maintaining a house. To do this effectively you need the right tools for the right job. If one was to remove the screwdriver from your tool box, could you still build and maintain the house? The answer would be yes but it would be a much more difficult process. The same logic holds true for investors and the usage of options. By not understanding and using options, one is just removing that one powerful tool from their investing tool kit and putting themselves at a disadvantage. No matter what type of investing one does there is always a place for options. As the world of option trading is huge, this article will focus on using option (covered calls) within an income generating portfolio.

Before we begin, we should focus on the goals of an income portfolio as that definition can mean different things to different people. For this article, the goal of generating a competitive cash flow and a high yield is the primary endpoint or goal for the income portfolio. Capital gains are great too but that is not the major focus. These goals will come into play as one continues to read into the option ideas and trades below.

Covered Calls

Of all the different types and styles of option trades, the covered call is one of the easiest trades to comprehend and understand. The basic premise of the trade is that you, being the seller of the call, is offering to sell shares of a stock you already own for a specific prices sometime in the future. For your trouble, the buyer of the call is willing to pay you a specific amount upfront to seal the deal. If you can grasp this concept then you basically understand covered calls. But let’s establish some of the ground rules option traders’ play by for the covered call.

  1. You must own the shares of stock you sell calls for. Most of the time one call option is equal to 100 shares but not always, so make sure to check before you just jump into the trade.

  2. You can sell your call(s) in different lengths of time. The farther out in time you sell your calls, the more money you will receive based upon time value.

  3. Standard options expire on the 3rd Friday of the month you sell the call, but beware the buyer of the call can make you hand over your shares at any given moment.

  4. To keep the covered call status, one cannot sell the shares until they buy back the calls first. Not doing so can put one in a dangerous naked short call position which can be risky, to say the least.

So the question is why would an income investor be interested in this? One answer is that one could sell covered calls to add further cash flow to the dividends that they already will be receiving. See below for some real time trade ideas to illustrate the concept.

Enerplus Corporation (ERF)

Established in 1986, Enerplus is one of Canada’s oldest and largest independent oil and gas producers offering investors a high yield combined with moderate, profitable growth potential from resource plays across Western Canada and the United States. Enerplus has a balanced portfolio of crude oil and natural gas assets in large resource play areas that provide both a stable production base and growth potential. Currently ERF has a great payout rate and a steady dividend of $0.18 a month making a yield of 7.2%. For the last month ERF has been stuck in a trading range of a high of $32.50 to a low of $30 as shown by the chart below.

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First, let’s buy 500 shares of ERF for $31.11 (July 15, 2011 closing price) for $15,555. Now look at the option chain below.

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Let’s sell 5 January 2012 $32 calls and get $1.25 a piece for them (we might be able to get more as there is a range between the bid and ask but we will stick to the bid amount for now). That will net us $625 right away into our accounts. Now as we wait till January 2012 to come along, we should also collect the monthly dividend of $0.18 for August through January, adding another $540 ($0.18 dividend*500 shrs*6 months). So when January 2012 comes, and our shares have not gotten called away early, we should have $1,125 ($625+$540) in income. That is a 7.23% yield for six months or annualized yield of over 14%. Not too bad, but let’s take a look at all the angles and risks involved.

  1. Early assignment – There is always a chance that the buyer of our calls might come and take our shares early before expiration date. Since our cost to buy the shares was $31.11 and they have to pay us $32, we make a profit of $0.89 per share right off the bat, plus we get to keep our $625 they paid us to buy the calls in the first place. So a 6.8% return ((500shrs*$0.89) +$625)/$15,555)) on our investment plus any dividends we picked up along the way.

  2. January 2012 Share Price $32 – The best of all outcomes would be for ERF’s price at January 2012 expiration to be at $31.99. At that point the income investor would have collected six months of dividends and will get to keep all of the option premium they received on the initial sales. The option itself will expire worthless, and the income investor would keep the shares and have paper gain of $0.89 per share. At $32 and above the shares should be called away if the options are not purchased back on the expiration date. Most investors will buy back the covered calls they sold for just a few pennies. So if Enerplus on expiration day is trading at $32, and one wants to keep the shares for another option trade later, they would simply buy the calls back and probably spend $0.05 or less per share. The original calls we sold were $1.25 so by the time we buy them back for $0.05 the total income generated from the covered calls was $600 ($1.25-$0.05)*500 shares.

  3. January 2012 Share Price $40 – This situation is always rough for the income investor to wrap their heads around. Since our calls are sold at $32, that is all we can sell the shares for. The stock trades at $40 so at expiration we are leaving $8 per share of profit on the table. At this point the income investor needs to remember that capital appreciation, while awesome, was not the major goal of the trade. The income investor still gets to keep the $625 of option premium, the $540 of dividend income, and $445 of capital gain for a total of $1,610 in profits for a 10.3% return in six months or a 20.6% return annualized.

  4. January 2012 Share Price $20 – In this situation the stock price fell in value rather badly. One misconception with investors is that once you are in an option trade you have to wait until expiration. This is not true; one can always make adjustments or even just exit the trade whenever the need arises. In our case here, the income investor, keeping an eye on his portfolio, would have seen the weakness in ERF and would have hopefully taken action before the share price fell to $20. Like any type of trading, investors will set stops either in their heads or on a trading order. Once that stop price is reached, whatever that price is, the investor would simply buy back the calls and then sell the stock. As the stock price drops so does the price for the calls. We sold the calls at $1.25 when the stock was trading at $31.11. If the trade stop is set at $28 on the stock price, the price to buy the calls back will be much cheaper than $1.25, depending on the date the trade. To sum it up, the income investor would get to keep any dividends paid out up to the point of the exiting trade. To this amount add the difference between the original option premium received of $1.25 less what has to be paid back to close the calls. The positive here is that this amount can be used to offset the loss on the actual sale of the stock. It won’t cover the total loss but will provide a small cushion or sorts. The income investor without the covered call in place would have no such cushion and would eat the entire loss.

Here is a graph that best presents the total possible outcomes.

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Now let’s look at a couple of other examples where the covered calls can be used to the same effect. We won’t go over in detail the possible outcomes like above as one can quickly calculate the end results by referring back to the ERF example above or the provided graph for each trade.

Philip Morris International Inc. (PM)

Philip Morris, through its subsidiaries, engages in the manufacture and sale of cigarettes and other tobacco products in markets outside of the United States. Its international product brand line comprises of such well known names as Marlboro, Merit, Parliament, Virginia Slims, and Chesterfield. The company operates primarily in the European Union, Eastern Europe, the Middle East, Africa, Asia, Canada, and Latin America. Currently the company trades at $66.93 a share and has quarterly dividends of $0.64 a share making an annual yield of 3.80%. Now PM is a company operating in a very strong business sector. The dividend is decent but not great at its current level, but owing a blue chip company like this is a must for most investors. PM is has been trading in a range between $65 and $73 a share since late April of 2011. See chart below. Here is one possibility on how an income investor might own this stock yet boost the income.

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First buy 300 shares of PM for the going price of $66.93 which will cost $20,079. Follow this initial purchase up with selling 3 January 2012 $67.50 calls for $3.25 a piece. That will net the seller $975 right away. Add to this two more dividend payments of $0.64 a share for our 300 share holding and that would be another $192. If all goes according to plan we should net $1,167 (975+192) for the six month time period which is a 5.81% yield but annualized is an 11.6% yield. If PM ends above the $67.50 strike price at expiration then we will add another $171 (($67.50 strike - $66.93)*300)) in gains as the shares are called away.

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Seadrill Limited (SDRL)

Seadrill Limited, an offshore drilling contractor, provides offshore drilling services to the oil and gas industries worldwide. It also offers platform drilling, well intervention, and engineering services. As of March 31, 2011 the company owned and operated 54 offshore drilling units, which consist of drillships, jack-up rigs, semisubmersible rigs, and tender rigs for operations in shallow and deepwater areas, as well as in benign and harsh environments. The company is currently distributing $0.75 per share per quarter which calculates to a 8.60% yield. The company’s shares trade for $34.81 at the time of this article. Since early April of 2012 the shares have been trading in a range of $32 to $36.

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In this example, let’s buy 500 shares of Seadrill at $34.81 for a total cost of $17,405. Follow that with selling 5 January 2012 $35 calls for $2.25 and the seller should net $1,125. Add to this amount two more dividend payments of $0.75 a share and we get another $375. If held to expiration the income investor would have pocketed $1500 ($1,125+$375) which calculates to an 8.61% yield for six months. Once again we annualize that number get 17.22% figure. If SDRL closes above our strike of $35 the investor will net another $95 in gains.

Another use for covered calls is to turn a non dividend producing equity into one that will generate cash via selling the calls associated against it. Since these companies do not have any dividends, most income investors will shy away as they do not fit into the goal of the portfolio. Selling the covered calls though will provide income and give the investor a much wider arena of stocks to choose from. Needless to say deriving an income stream from this type of investing can be a bit riskier so investors need to stay focused upon the stocks they sell the calls against.

Dendreon Corporation (DNDN)

Dendreon is a biotechnology company that is engaged in the discovery, development, and commercialization of therapeutics to enhance cancer treatment options for patients.This is one of the last companies that the retail income investor will look to for income. Moving away from being a speculative stock, DNDN is on the road to becoming profitable in selling its new prostate drugs.The company offers the right amount of volatility and stability for the use of the covered calls. The stock currently trades at $38.80 and has been trading in a range of $37 to $43 since April of 2011.

A more aggressive income investor might try to complete the following trade. Buy 300 shares of Dendreon at $38.80 for a total outlay of $11,640. Then sell 3 January 2012 $39 calls for $4.85 and net $1,455 (300shrs*$4.85). Once again if everything went well and the share price at expiration on January 2012 is at $39 a share or higher then the trade is a success. As the shares get called away one would make a small gain of $60 ($39strike - 38.80 cost)*300shrs. The real success here though is that the investor would keep all $1,455 covered call premiums which would make the yield of the trade 12.5% for the six months. Double that amount to get the annualized yield. Not bad for a non-dividend paying stock.

Market Vectors Agribusiness ETF (MOO)

Moving into yet another sector, consider the use of covered calls in an ETF like the Market Vectors Agribusiness ETF MOO. This fund seeks to replicate as closely as possible, before fees and expenses, the price and yield performance of the DAXglobal Agribusiness Index. The fund normally invests at least 80% of total assets in equity securities of U.S. and foreign companies primarily engaged in the business of agriculture, which derive at least 50% of their total revenues from agribusiness. Such companies may include small- and medium-capitalization companies. The ETF has a very small yield of 0.61% for the year and trades for $54.27 a share. Once again this would not be a solid choice for the retail income investor. Let’s see here how the use of covered calls here might provide that desired income.

First buy 400 shares of MOO for $54.27 a share for a total cost of $21,708. Then proceed to sell 4 November 2011 $55 calls for $2.25 providing $900 of covered call premium. MOO, since February 2011, has been trading in a range of $51 to $57. If all goes well by November 2011 and shares of MOO trade at or above our strike price of $55, then we have another successful trade. The $900 will be kept by the investor making a 4.14% yield for only 5 months. To this amount add the gain on the sale of the shares and your total return is 5.5%.

In conclusion, an income trader can really expand their horizons if they can gain an understanding of options and their uses. The covered call is a powerful tool that no investor should be without. It should be used only where appropriate and in the right context, but when used properly it can really make a difference for an income investor. Needless to say, this article serves as only an introduction to covered calls and investors should complete more in-depth analysis before investing. Our next article will cover the use of put options to generate income for the yield hungry investor.

Disclosure: I am long ERF, DNDN.

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