There’s an ongoing discussion in the comments section following many dividend investing articles about the use of options. However, you really can improve your annual yield from say 4% to over 12% with only a little study and with almost no risk. This article is about how to do this.
A few weeks ago I wrote my first article (Dividend Investors: Improve Your Yield on Cost) about how to get a higher yield-on-cost using a simple, low-risk approach of selling cash secured puts. Today I’m going to cover something even more basic: increasing your annual income using covered calls.
A few days ago I read the following comments in Norman Tweed’s latest article, Core Portfolio For The 59 Year Old:
- Norman Tweed: “Options are a more risky form of investment according to Vanguard.
- Chowder: “Several years ago, I ordered a couple of books on options so I could learn the different option strategies. As I started to read, I said to myself, I really don't want to do this. So I don't and I won't. Ha!”
- Surfgeezer: “Options are a tricky thing, not hard.” “Was not happy with the idea of losing stocks and starting over on my ROI."
- Chowder: “To me, that's another wall of worry I don't want or need, not to mention the money that gets tied up that could be used to build existing positions.” “In my style of dividend growth investing, I want as little "timing" decisions as possible and options are nothing but timing.”
These are excellent comments by some very smart people. However, most of these comments are related to other types of options trades than covered calls. I’d like to try and clear up some misconceptions about “covered calls.”
Selling a covered call is easy and low risk. I won’t go into all the details here. I will limit this article to describing the basic concept and for simplicity, I’ll assume this is in an IRA. If you want more details, type covered calls into the Seeking Alpha search box and you’ll get plenty of articles to read. Here’s a recent one by Parsimony that gives more details than I will go into here.
Let’s say you own Procter & Gamble stock (NYSE:PG) and this is one of your core dividend growth (DG) stocks in your hold and monitor portfolio. While you are monitoring, you hope it will be a hold forever member of the portfolio.
At the time of this writing, PG closed at $61 and its dividend is $2.10/yr for a yield of 3.44%. You can sell the January 65 call and receive $0.34/share.
Between now and January 20th, when the option comes due, the stock price will go up, down, or stay the same. I’ll cover what happens in each scenario.
Stock Price Stays About the Same or Goes Down Scenario
If the stock price stays below $65 (an 85% probability), you just keep your $0.34 on a $65 risk. This is a 0.52% return ($0.34/$65) in 54 days or about 3.5% annualized. This doubles your annual return. Who wouldn’t be happy with this? And note, the stock price can go up from $61 to $65 and you just keep your cash for selling the call.
As an alternative, you could sell the December $62.50 call for $0.58. Since we received $0.58 on a $62.50 risk, this is a 0.93% return in 19 days. The annualized return would be about 18% with a 70% probability. Not bad on top of your dividend.
What’s the catch? The normally cited risk for this is the potential loss in capital. If the stock drops to say $55, then while you made a little bit on the call, you lost $6 on the stock. For those who worry about “total return” this is important. To my DG colleagues, this isn’t an issue because we were going to hold the stock anyway. “All” we did was make a 3.5%-18% return on this call on top of our 3.5% dividend.
Stock Price Goes Up Scenario
This is the scenario that unnecessarily gives DG investors fits. It’s the one “every” DG investor worries about. What happens if my stock gets called away? Yikes, the sky is falling! Okay, let’s think through this.
Situation I: The current price is $61. If we were conservative and went after the 3.5% annual return, the stock could go all the way to $65 with no worries. If we were a little more aggressive and wanted the 18% annualized return, as long as the stock goes up less than $2.50/share in 19 days we get our 18% (annualized) return. All is well in these situations. We pocket the money and do the same thing again for the next month.
Situation II: What if the stock price goes higher than the strike price and the stock really does get called away on expiration Friday? Answer: buy it back on Monday. When you do this, yes, you lost a $7.95 commission. And if the stock moved up a few pennies over the weekend in after hours trading you lost that too. So you may have lost $10, heck maybe $20 or $30. So what. In our two scenarios above, you made between $340 and $580. If once or twice a year you paid a $7.95 commission to buy the stock back in order to make hundreds every month, that’s a terrific ROI proposition.
You didn’t lose the money you’ve been getting from the covered call, which is WAY more than the commissions. You didn’t lose your dividend. Because this was in an IRA, you didn’t pay any taxes. Did you lose anything from a yield-on-cost perspective? In my mind the answer is no. Does the fact you didn’t own the stock over the weekend change your conceptual return since you bought it? I don’t see why it should. And, I didn’t mention it but a Total Return investor would be ecstatic because they made money on the call and on the stock price increase and they can buy it back the next trading day. What’s not to like.
Tactics: Almost everyone that teaches options trades will tell you to exit the trade about a week (4-10 days) before the expiration date. This is because options are virtually never exercised before the expiration date. Exiting the trade means you buy back the call and sell another one the next month out. This is called a roll. Most of the time, the income from the sale is higher than what you pay to buy back the current. It’s a function of what the stock price is relative to the strike price at the time of the roll.
You made money the first month by the amount you earned from selling the call. This month you make money by the difference between buying back the first one and selling the next one. If the stock makes a run up, you may not make any money on your roll or you might even let it get exercised. As I explained above, it isn’t the end of the world if this happens. You made money.
The other item to watch is the ex-dividend date. If this date happens to fall in the last week before expiration Friday and if the stock price is near the strike price, it would be to the buyers benefit to call it away early from you and collect the dividend. In this scenario, you just need to “roll” the call a few days before the ex-dividend date.
Risks & Next Steps
I covered the two “big” risks normally associated with covered calls. One, the stock price drops a few dollars so total return drops. For DG investors, this was going to happen anyway and you don’t care. Or two, the stock gets called away because it went up in value. Here you made money on the call, on the stock price increase, on the dividend if the dividend was paid that month, and in return you have to spend a few minutes to buy the stock back the next day. These are the worst things that can happen to you in return for making a 3.5-18% annualized return on top of your dividend.
Let me now go back to the early points I started this article with.
- Options in total are more risky but don’t confuse this generalized statement with covered call options, which are very conservative for DG investors who plan to hold their stocks.
- Reading a book about all the types of options trades is intimidating. Don’t do that. Just learn how to do covered calls.
- Yes, your stock could possibly get called away. However, you can manage your covered calls so the stock doesn’t get called away. And if it does, just buy it back the next day. You made good money. It’s no big deal.
- Some types of options trades do tie up capital and do rely on timing. However, not covered calls. For DG investors they tie up no incremental capital because you already own the stock, and you’re going to roll them forward every month about a week before expiration so timing is a small issue.
The only two concerns that I believe are warranted are the time involved and your ability to sleep at night. If managing your current DG portfolio is all the time you want to spend and your current annual return is plenty, then don’t bother to learn how to do covered calls. Or, if you just want the safety of a quarterly dividend and you would stay awake at night worrying about the potential issue of buying back a stock that gets called away, then again this strategy isn’t for you.
On the other hand, if doubling or tripling or maybe even quadrupling your return is worth about an hour a week to you, then start learning how to do covered calls on your DG stocks.
Summary: Covered Calls are easy and for DG investors they are conservative and should be very attractive. They will double your annual cash flow, if not more.
Disclosure: I’m a retired P&Ger, so I’m long PG.