Vale (NYSE:VALE) may not pay a dividend in 2016, and for good reasons. Many commodity prices have been dropping over the past year, including iron ore which is one of Vale's main revenue generators. Then there is the ongoing lawsuit in regards to the Samarco dam disaster that could cost Vale billions. And there are numerous economic and political issues that are going on within Brazil that create more uncertainty for companies with headquarters in Brazil.
So with no dividend expected to be paid by Vale in 2016, how can an investor generate income from owning the stock? One strategy that we can use is to write covered calls against Vale's shares. In this article, we will discuss how this can be accomplished, what amount of income is estimated to be received from this strategy with various call options, and compare Vale's potential covered call income to that which could be generated from some of its competitors.
Please be cognizant of the fact that options have additional, unique risks and are not suitable for all investors. Additional information about options can be found here. Also, we are not recommending that an investor initiate this strategy. Instead, we are simply pointing out a strategy that we believe looks interesting when considering the pricing levels of the stock and its call option contracts.
Covered Call Strategy
A covered call option strategy is an income producing strategy where an investor sells (writes) call options against shares of the stock they already own, or the investor simultaneously purchases stock and writes call options on the underlying stock. For the type of call options we are referring to, each call option contract gives the buyer the right (but not an obligation) to purchase 100 shares at the strike price. There are several variables that go into calculating option prices and we are not going to discuss all of the variables. An important variable that we will be covering is implied volatility because it is the main unknown variable in the calculation and can be thought of as the market's estimation of volatility for the underlying stock over the remaining life of the option.
Not only does the covered-call strategy produce income, it also creates a limited hedge whereby the premiums received from writing the calls could help to offset some losses in the stock.
Assuming we did not already own Vale's stock, to set-up the trade, we could simultaneously buy 1,000 shares of Vale and write 10 call option contracts against the shares. The premium we collect from selling the options are what is considered as the income received and we can even think of it as a yield.
Estimated Income from Covered Calls
If Vale is trading at $2.63 and we are able to sell a call option for $0.20 with a $5.00 strike that expires in January 2017, the income yield would be 7.60% (0.20/2.63=7.60%). The bid/ask prices for several of Vale's call options are below, at the time of writing.
In this table, we show the theoretical income yield from the covered call trade for options with different strike prices. The stock price and bid/ask option prices are as of 2/12/16. The "Gain to Strike" is simply the theoretical gain from capital appreciation that could be earned if Vale's stock price went above (or equaled) the option strike price. For example, if Vale's price went from $2.63 to $6.00 and our short position in the call options had a $5.00 strike price, the holder (long position) of the call option could exercise their option and buy the stock from us for $5.00, effectively capping our gain. This ceiling on covered call strategies is an opportunity cost of this type of strategy and it exists while the short call options are held.
The "Total Max Gain" is the capital appreciation gain up to the strike price, plus the income received from writing the call options.
Other important assumptions:
- Call can be written at bid/ask mean price - Wide bid/ask spreads need extra scrutiny
- Gains assume contract will be held until maturity
- No commissions, fees, or other expenses are included
- Shares will be called away if the stock price reaches or exceeds the strike price
- The max gain only considers gains that could be earned over the 11-month period
- No consideration given to stock being held beyond contract expiration
- No taxes are considered
Comparing Against Competitors
Next we will look at potential income generated from two of Vale's competitors, BHP Billiton (NYSE:BHP) and Rio Tinto (NYSE:RIO). The two tables below show various theoretical yields that could be earned by writing different call option contracts. Note, any projected dividend income is not reflected in the possible gains, and this data is at time of writing.
Viewing the table above, we can see that both BHP and RIO would generate less income from a covered call strategy when comparing them to Vale and considering comparative total max gains. Basically, this means that Vale's options are trading with a higher implied volatility which may reflect the market attributing relatively greater risk in Vale. Investors should expect riskier companies' options to trade with relatively higher implied volatilities. How much higher? That is very difficult to say and each investor will likely have their own opinion regarding perceived risk.
To look at comparative total max gains, we can view the table below which shows a strategy that could allow for a total max gain of 50.38%, 47.56%, and 45.55% for Vale, BHP, and RIO, respectively. While these total max gains differ slightly, we believe they are close enough to compare covered call yields. Click to enlarge
The table shows that Vale's comparative call option is trading with an implied volatility that is around 65% higher than BHP or RIO. This may be justified because Vale is considered by many as a risky investment. Also, implied volatilities tend to increase before earnings are announced and Vale is scheduled to announce its earnings on February 25th. RIO already announced earnings on February 11th and BHP is scheduled to announce earnings on February 22nd.
Even if we assumed that RIO and BHP were going to pay a dividend that yielded 3% or 4% and that Vale would pay no dividend in 2016, and we had the ability to set up a covered call strategy in any of the three companies, the strategy using Vale may yield an income amount that is double that of RIO or BHP. Risk, tax treatment for particular sources of income, investor preferences, and many other things need to be considered before we would initiate any of the trades discussed. But we believe that writing covered calls against Vale is currently an interesting strategy based on the information presented.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Options involve risk and may not be suitable for all investors. Information in this article represents the opinion of the author. Opinions expressed herein are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment, tax, legal or any other advisory capacity. The opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice. The author explicitly disclaims any liability that may arise from the use of this material.