Generating Year-End Income (Part I): Covered Calls

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 |  Includes: AEE, AGNC, BMY, FE, KMB, MO, NLY, PFE, PM, T
by: Parsimony Investment Research

As year-end approaches, income investors should continue to keep an open mind about various strategies to generate income. Bernanke and the Fed have all but promised at least another year of low interest rates, so yield will be elusive again in 2012.

One strategy that we recommend in a neutral or stagnant market is a "Buy-Write" strategy. With a buy-write strategy, an investor simultaneously purchases a stock and overwrites a call on that underlying position (also known as a "covered call" strategy if you already own the underlying stock).

Note: Since the investor is long the underlying stock, this strategy will only offer limited downside protection if the stock experiences a significant decline (so downside risk should be managed accordingly).

COVERED CALL BASICS

Source: Options Industry Council

The covered call is a strategy in which an investor writes a call option contract (for an equivalent number of shares) on a stock that the investor already owns. This strategy is the most basic and most widely used strategy combining the flexibility of listed options with stock ownership.

Though the covered call can be utilized in any market condition, it is most often employed when the investor desires to either generate additional income (over dividends) from shares of the underlying stock, and/or provide a limited amount of protection against a decline in underlying stock value.

While this strategy can offer limited protection from a decline in price of the underlying stock and limited profit participation with an increase in stock price, it generates income because the investor keeps the premium received from writing the call. At the same time, the investor can appreciate all benefits of underlying stock ownership, such as dividends and voting rights, unless he is assigned an exercise notice on the written call and is obligated to sell his shares. The covered call is widely regarded as a conservative strategy because it decreases the risk of stock ownership.

IDEAL CANDIDATES FOR A COVERED CALL STRATEGY

In the general, low beta dividend stocks in stable sectors (consumer staples, health care, and utilities) are ideal for a covered call strategy. In addition, low beta stocks that benefit low interest rates (like REITs) are also ideal in the current market environment.

Stocks with low betas will tend to be less volatile than the general market and defensive stocks tend to hold up well in a market downturn. Since you are selling upside volatility with a covered call strategy, you want actual volatility to remain low after you overwrite a call on your stock position. Low beta stocks are less likely to surge to the upside in a short term rally, making the probability of assignment lower.

The table below highlights some good candidates for a covered call strategy:

CHOOSING THE RIGHT STRIKE PRICE

There are three key components to look at when choosing a strike price for a covered call strategy:

  • Premium Yield (%) - The additional yield generated by the call premium (which is your downside protection from the current price). The more volatile the stock, the higher the premium (i.e., the higher the risk).
  • Margin of Safety (%) - The margin of safety is the amount that the stock would have to drop from the current level (before expiration) to completely offset the call premium and the dividend yield. Note: If the underlying stock does not pay a dividend, the Margin of Safety will be equal to the Premium Yield.
  • Upside Profit (%) - The upside profit, which assumes that the option is assigned at expiration, is equal to the premium received + dividends received + the difference between strike price and current price. The more volatile the stock, the higher the expected upside profit.

YEAR-END TRADE RECOMMENDATIONS

Below are the specific call options that we would recommend selling on the candidates that we highlighted above. On average, the 4-month premium yield is 2.2%, with a margin of safety of 5.8%% and upside potential of 11.2%. Note: This analysis does not include transaction costs. Click to enlarge:

Click to enlarge

EXPIRATION DAY CONSIDERATIONS

As expiration day for the call option nears, the investor considers three scenarios and then accordingly makes a decision. The written call contract will either be in-the-money, at-the-money or out-of-the-money.

If the investor feels the call will expire in-the-money, he/she can hope to be assigned an exercise notice on the written contract and sell an equivalent number of shares at the call's strike price. Alternatively, the investor can choose to close out the written call with a closing purchase transaction, canceling his obligation to sell stock at the call's strike price, and retain ownership of the underlying shares. Before taking this action, the investor should weigh any realized profit or loss from the written call's purchase against any unrealized profit or loss from holding shares of the underlying stock.

If the investor feels the written call will expire out-of-the-money, no action is necessary. He/She can let the call option expire with no value and retain the entire premium received from its initial sale. If the written call expires exactly at-the-money, the investor should realize that assignment of an exercise notice on such a contract is possible, but should not be assumed.

If unassigned, the investor will also need to decide whether or not to sell the underlying stock at this time to exit the trade completely. If the investor expects the stock to remain neutral, he/she may decide to write another call on the stock and repeat the process.

***Part II of this series will discuss a put selling strategy***

Disclosure: I am long AGNC, NLY, MO, T.