For Dividend Income Investors: A More Tactical Approach To Covered Calls

Includes: INTC, MCD
by: Richard Bloch

The problem with the term “covered calls’ is that it means different things to different investors, with some financial experts recommending covered calls as a strategy for generating income on an ongoing basis.

Perhaps, but I don’t think dividend income investors, those who maintain a portfolio of high-quality dividend stocks, should be selling calls on a regular basis. However, there are cases when it makes a lot of sense – especially if you have some big gains and want to make some tactical adjustments to your portfolio.

MCD: Good performance, but perhaps time to lighten up?

Let’s say you own 500 shares of McDonald’s (NYSE:MCD) that you’ve acquired over the past few years at an average price of $50 – or $25,000. With the stock at $95.54 on December 1 , those shares are now worth $47,470. With a $2.80 dividend, you’re getting $1400 per year or 5.6% on your original $25,000.

You’re pleased that MCD has done well this year, outperforming the S&P 500 by 28% so far this year.

But maybe it’s time to lighten up, taking some profits by selling 100 shares of MCD. Perhaps you might want to reallocate funds to other stocks, diversify into another sector or buy another stock that you think is undervalued now.

Some investors like to scale out of a stock through limit orders above the market. Others like to set trailing stops. You can do both if you want and earn a bit of extra money by selling calls.

The trade: Sell the January 95 call

As of December 1 mid-day, you could sell 1 of the January 21, 2011 95 call on MCD for $2.77 or about $270 if you allow for commissions. You’re only encumbering 100 shares out of your holdings, the 100 shares you were thinking of selling anyway.

And if you want to make sure that you can get at least $85 for your MCD shares, you could always set a stop order at that price. If that were triggered, you’d want to buy back the call you sold (which would cost way less than you sold it for) to make sure you’re not called on another 100 shares.

Here’s how that transaction looks.

So there are three possibilities

1) The stock sits above the strike price at expiration and your 100 shares are called away.

2) The stock falls and you are stopped out at 85 (or perhaps less if the market gaps)

3) The stock stays above 85 and less than 95

Where would this leave you? Here’s a table that shows the outcomes.

As you can see, whether you sell your stock for either 85 or 95 you’d be reducing your overall cost basis. You’ll be collecting less in dividends if you sold those 100 shares, but that amount would represent a higher yield against to what you’ve invested. And besides, MCD seems to be continuing to raise its dividend.

If the stock stays in the 85 to 95 range, you’d still own 500 shares of MCD, but you will have reduced your cost basis by 54 cents per share. Then you could repeat this process. In fact, as long as the stock stays in this range you could conceivably reduce your cost basis by another 54 cents per share in the next couple of months, then perhaps by another 54 cents in future months.

But when the stock exits that range, that tactical trading approach would come to an end. No more selling calls (unless you’re interested in parting with another 100 shares of MCD for some reason).

Also note that there may be tax issues involved with these trades so you’d want to know where you stand with respect to potential taxable events.

Temporary, not perpetual monthly income.

Here’s where I get off the train with those who advise selling calls on stocks like MCD every month as if it’s some magical resource for generating dependable income.

So once you’ve sold your 100 shares, you stop selling calls. You do not count on ongoing income. You can’t. Otherwise you risk losing more of your MCD shares.

Greg Group adopted an interesting term, “perpetual covered call” for continuing to sell at-the-money call options month after month. But I believe that’s unsuitable for dividend income investors. In fact, I showed that Greg Group’s approach for perpetually selling Intel calls (NASDAQ:INTC) would have lost money over the last year.

So for the dividend income investor, selling calls is not an overall ongoing strategy – it’s an occasional tactic, one that can offer a little extra return depending upon how you execute it.

Disclosure: I am long MCD, INTC.