By Mark Bern, CPA CFA
In part five of this series I introduced the concept of selling call options to enhance income from a conservative, dividend-paying portfolio. For the detailed, simply to understand basics on that strategy, please review "Part 5." The emphasis of this series remains buying and holding stocks that will preserve an investor capital while throwing off a decent dividend income stream. Parts 5 through 8 are for those investors who would like (or need) to earn more than 3.8% from their portfolio. The objective of selling call options is to increase that income to a range between 8% and 10% per year.
This article will simply concentrate on the four companies first recommended in "Part 4." Those four companies are IBM (IBM), CSX (CSX), 3M (MMM) and Baxter International (BAX). If you haven't read Part 4 of the series what you will find there is my reasoning behind why I want to own each of these stocks. The series began with the original four companies introduced in "Part 1" here. Those four companies are Procter & Gamble (PG), Johnson & Johnson (JNJ), Waste Management (WMT) and El Paso Pipeline Partners (EPB). Thus far I have only one recommended three call options to be sold in the prior articles due to the low premiums available at the time of the articles. I intend to provide updates, probably in the comment section of each article if there are call options with premiums that meet my requirements available on a particular day, so if you are interested in that feature I would suggest checking the box at the top of the comments section to be notified whenever a new comment is made to the article.
IBM is one of the world's largest technology companies. The current price (all quotes in this article were actual prices between the hours of 3 p.m. and 4 p.m. of Friday, February 17, 2012) of this stock is $193.63 paying a dividend of $3.00 annually per share for a yield of 1.6%. I like selling the April call option with a strike price of $200 and a premium of $3.10 (bid) and $3.20 (ask). Assuming that the price does not spike up and the call gets exercised, we would collect the premium of $310, less a commission of about $9 for the first contract (the cost drops to $1.50 or less per contract for additional contracts if you sell more than one), to net $301 for a return of 1.55% in two months or 9.3% annualized. The buyer would need the price to rise above $203.10 before expiration (April 20, 2012) to make a profit. The market seems to be stuck in a range for the time being so I think this one is worth the risk. If the stock price rises and remains above $200 on the expiration date, we would have our stock called away at the strike price. Our actual sale price would equate to about $202.95 after accounting for the commission of selling the call and the exercise fee charged by the brokerage (your fees may vary significantly from those that I use for illustration but I try to use an average to remain conservative). That would be a gain from the current price of 4.8%. Each investor needs to weigh the risk of having their stock called away against the potential gain from the premiums collected.
CSX Corporation is one of the four largest railroad companies in the U.S. covering the eastern U.S. and two provinces in Canada. The current stock price is $21.62 with a dividend of $0.48 yielding 2.3%. The best contract I find today is the May call option with a strike price of $22.50 and a premium of $0.75 and $0.77 (ask). Assuming we can get the bid premium if we sell the call we would collect $66 (net of commission) for a return of 3.05% for three months or 12.2% annualized. However, since the stock has already fallen from its recent short-term peak of $23.71 set on January 12th and the expiration of the call option falls at about the mid-point of the second quarter, I am hesitant to recommend this one. By mid-May I am expecting a little more light to be shed on the EU sovereign debt situation (wishful thinking, I know) and a positive surprise from across the pond could stir investor hopes again. Carload count in North America is up 1.9% in the most recent week compared to 2011 according to a "press release" (here) by the Association of American Railroads. Thus, I'd like to see this stock closer to $23 before I'd like to sell a call. The return is tempting, but I think it would be better to wait on this one. My recommendation is to hold the stock and wait for a higher price at which to sell a call option with a shorter duration.
3M is a global diversified manufacturer and technology company. The current stock price is $87.60 with a dividend of $2.36 for a yield of 2.7%. The stock price is well off its 52-week high of $98.19 but very close to its recent short-term peak of just over $88. The stock traded below $70 in October and has experienced a nice rally of 25% since then in just four months. The price has been in a very narrow range for the month of February, appearing to be taking a well-earned breather. The best option I find to sell today is the April call option with a strike price of $92.50 and a premium of $0.77 and $0.79 (ask). The return would be only 0.78%, or 4.66% annualized. This falls short of what I require so I don't think it is advisable to sell a call on 3M today. My recommendation is to hold the stock and wait for a better premium to become available.
Baxter International is a large diversified healthcare company. The current price is $56.91 with a dividend of $1.34 for a yield of 2.4%. This stock is also trading flat for most of February after a huge rally. This breather is a necessary function of a healthy stock. Again, there are no options available that meet my requirements. One of the May options is close but due to the same reasoning as I posited earlier I am hesitant to pull the trigger just yet. I believe that patience will reward us with a better option to sell over the next two weeks. My recommendation is to hold the stock, collect the dividend and wait for a better opportunity on the call options.
In summary I am making only one more recommendation today, on IBM, bringing the total to just four this week. In retrospect, I may have decided to write these articles a week or two later than I should have since the market seems to be trending lower and may not provide the opportunities to sell calls that I had hoped. We'll just have to see what tomorrow brings as the volatility seems to be rising and things could change quickly.