Covered Calls With Oatmeal And Red Bull

by: David Jonas

In a previous Seeking Alpha article I described my approach to covered call investing. I'll recap the key tenets of that approach here:

  • I look for two types of companies in which to establish covered calls:
    • Mature, blue-chip, low-beta, dividend-paying companies. Covered calls in these companies represent my "Oatmeal" trades: Oatmeal is a bland, safe, healthy food that mom approves. A diet consisting only of Oatmeal leaves one regular and content, but also listless, dull, and hungry for excitement. Therefore I complement my Oatmeal trades with covered calls in...
    • High-momentum, volatile growth stocks, which provide the fodder for my "Red Bull" trades. Like the eponymous beverage, these are high-yielding, seductive trades that get ones juices flowing and heart racing. They offer enormous upside, but also significant risk. Trading exclusively in the realm of the Bull can bring an investor, like poor Icarus, too close to the sun, and we all know what happened to him (if you're not familiar with the tale of Icarus, it ends with "splat".)
  • With all of my covered calls, my goal is share assignment. In other words, I don't want to own the shares beyond option expiration. To maximize my chances of assignment I only sell in-the-money or just out-of-the-money calls.
  • With my Oatmeal trades I sell calls that expire in 3-6 months, and I time the trade so that I receive 1-2 dividends (barring early assignment) to supplement the option premium. I seek 12-18% annualized yield, after expenses, with my Oatmeal.
  • My option expiration horizon for Red Bull trades is 30-45 days, and my annualized net yield threshold is 40%.

During times of extreme market churn, it's tempting to stick to Oatmeal, but I find that down markets also provide great opportunities in beaten-down Red Bull stocks (though their price swings may necessitate a Scotch & Maalox chaser).

Enough about food, drink and mythology, though. In this article I'll present today's top Oatmeal trades. I'll share Red Bull ideas in a subsequent piece.

To compile the Oatmeal portfolio I applied the following screens:

  • I only considered companies that:
    • Are rated 4 or 5 stars by both Morningstar and S&P; and
    • Possess a "wide economic moat", according to Morningstar (click here for an explanation of the Morningstar "moat").

To be sure, an S&P seal of approval lost some luster after the company whiffed in rating those pesky sub-prime mortgage CDO's. However, S&P insists that its equity and CDO units are totally independent, and if we can't trust S&P, who can we trust?

Certain companies that are rated highly by Morningstar but not covered by S&P, or vice versa, did not make the cut. An example is a company called International Speedway (NASDAQ:ISCA), which Morningstar gives 4 stars but which S&P does not cover (and which makes me wonder if one of S&P's CDO guys hired on with Morningstar?)

  • I eliminated companies that failed any of the following criteria:
    • Minimum share price of $15.
    • Minimum 2% annual dividend yield.
    • High call option liquidity. I applied this screen subjectively by scanning the option tables for each candidate company, and eliminating those with fewer than thousands of open contracts across a range of strike prices and expiration dates.
    • Minimum yield of 12% if assigned.

Here are the 18 companies that passed these screens, sorted by annualized yield if assigned. I hesitate to call these "quality companies", because in this age of sleight-of-hand finance and Alice-in-wonderland price gyrations, when down feels like up and up like down, nothing is as it appears. But I think it's a pretty strong slate.

Please note:

  • Only two companies are rated both 5 stars by both Morningstar and S&P. Drumroll please.... XOM and ORCL.
  • S&P and Morningstar ratings are as of September 5, 2011.
  • Annualized yield figures:
    • Reflect purchasing 100 shares and selling one option contract on September 6, 2011;
    • Include three income components: Share price appreciation, option premium, and dividends; and
    • Are after expenses. In calculating expenses I used my broker's fee schedule:

$6.99 commission
$.50 per contract
$19.99 assignment

  • For each company, I selected the first out-of-the-money strike price for the specified expiration date.
  • Share prices and option premiums are as of September 5, 2011.
  • As always, perform your own due diligence before you invest.

Next up is the Bull. Get ready!

Disclosure: I am long XOM, MSFT, ABT, JNJ.