Most income investors are familiar with the strategy of selling calls on stock owned, for additional income. If the call expires worthless, the realized call sale income adds to the dividend income, assuming the stock is a dividend-paying stock, boosting the overall return. If the option is assigned, and the stock must be delivered to the option buyer, the call seller is "covered", by virtue of already owning the shares that must be supplied. The only downside is that the call seller will forgo any gains in excess of the call's strike price. Frequently, in the case of early exercise, the seller will also lose out on a dividend that was expected, as an alert option holder exercises the option just before the ex-dividend date, thereby "stealing the dividend", forcing the shares to be sold via assignment.
The preceding introductory paragraph was copied verbatim (mostly) from my recent article on selling cash-covered puts, as I contrasted that strategy with selling covered calls. While it provides a reasonable overview, it does not provide much detail as to the results that can be obtained with the strategy. To do that, I have analyzed in depth some of my own experiences in selling covered calls, to get to the real truth in answering two key questions:
- What is a typical total return when selling covered calls on a dividend stock over a time period?
- How does that compare with what the return would have been if everything had been the same, except that no calls had been sold?
It wasn't easy, but I'm satisfied that I have come up with some answers that should prove interesting to any investor following this common practice.
The total return when selling calls on a dividend stock over a time period is comprised of three components: capital gain / loss on the stock sale, real or hypothetical, actual dividends collected, and gains / losses on options sold and, when applicable, bought back. I am defining these two major scenarios as "yes options" and "no options". Of course, for the "no options" scenarios, the third component is zero, so there are only two components. The first challenge in the analysis was to define the appropriate time frame for comparison purposes. I have decided that the time period should start with the date that the first call option was sold, and should extend through the end of the day that the last option expired, or was assigned. The dividends collected will be identical under all scenarios, and will only include those for which the ex-dividend dates occurred on or after the day that the first option was sold, and before the day that the stock was assigned, or theoretically sold.
Now comes the tricky part. Since I had owned the stocks for some time before selling options, I decided I needed to consider two scenarios for defining the cost basis of the stocks: the first scenario will consider the actual purchase costs, and the second scenario will consider a hypothetical purchase cost, at the price that prevailed, to the minute, when the initial option was sold. For the "yes options" sale prices, I used the strike price of the last option sold if the shares were assigned, which was in fact the price at which shares were sold, or if the option was not assigned, I used the stock's closing price on the option expiration day. For the "no options" sale price scenarios, I just used the closing price on the last day of the comparison time period, which was the day the last option was either assigned or expired under the "yes options" scenarios.
I will grant that this is a little messy, but sometimes getting at the truth takes some effort. I believe it will be easier for the reader to visualize after inspecting the tables of all relevant data, to be presented shortly. To make every effort to get to the real numbers, I have included commissions in all of the calculations, either actual commissions, or, in the cases of hypothetical buys and sells, estimated commissions. Further, in the case of the foreign stock example, the dividends shown are net of foreign tax withholding. All transactions took place in IRAs, so there were no tax considerations. I considered three stocks I have sold multiple calls against, for periods of a year or more, with varying results, to illustrate a range of possibilities.
The stocks are:
Unilever (UN) - This case represents the ideal situation, with multiple call sales, no assignments, and a stock price that has stayed in a range for the entire period.
First Energy (FE) - This case is also favorable, with no "dividend-stealing" early assignments, just an option expiration assignment, with a closing price on the expiration day of the last option sold only 86 cents above the strike, not a huge amount. The option could have been bought back before the end of the day to avoid assignment, but I chose to let the shares go, planning to buy them back later upon a decline.
NuStar Energy L.P. (NS) - This case represents the scenario that a covered call seller knows is possible, but hopes never happens; after selling the call, the stock shoots on up significantly above the call strike, and the stock is called away via an early assignment. Still, even though a much larger gain was forfeited, it is not the end of the world. The results of owning the stock, all components considered, was still a reasonable profit. It just doesn't seem like enough when the forfeited gain is considered. If you are going to be a member of this club, sometimes you just have to pay your dues.
I will update the reader at the end of this article, outlining subsequent actions I have taken regarding these three stocks, and my current positions.
The details of all actual and hypothetical transactions for each scenario, for all three stocks, are shown in the first table. The returns for each stock are shown in additional tables, one per stock. Shown are the returns, in total, and by component, so it can be clearly seen what the impact was on the total return of each component: capital gains, cumulative dividends over the period, and net proceeds from covered call sales. Returns are shown for the complete time periods, and also are shown as annualized values. The returns are shown in one cost-basis scenario using the actual cost of shares, including commissions, and then under a second cost basis scenario, as if the stock had been purchased concurrently as the first option was sold. Sales prices under the "yes options" scenarios are the assignment prices, if the shares were assigned, or the closing prices on the option expiration days, if no assignments occurred. The sales prices under the "no options" scenarios are the closing prices on the last day of the comparison period, which are the "yes options" exit days, for each case.
The results confirm that in the ideal and nearly-ideal cases, covered call selling increases returns significantly. For Unilever, the call selling income (from three calls sold) exceeded the dividend income, and for First Energy, the call selling income (from two calls sold) was nearly equal to 60% of dividend income. Only in the third case, NuStar Energy, with a significant gain forfeited, was the call selling strategy a loser. NuStar made a significant run during the period covered by the second option sold, and the shares were called away close to the peak of the run. Thus, the key to covered call selling is to avoid the huge forfeited gain scenario. To reduce the odds of that happening, one could limit selling calls to periods when stocks are elevated, ideally at or near 52-week highs, and select strike prices that are above even these levels. I believe a call seller should focus mostly on the strike price when making a decision - and should not let the call premiums drive the decision towards too low of a strike. One should select a strike far enough above the current market such that a sale would be acceptable, even desirable. Then, if the call premium available is not enough to be worthwhile, pass on that option; otherwise, put in a bid.
So, where are they now? My current status on these three stocks is as follows:
Unilever - I still have my shares, and I have sold yet another call, with expiration in August 2012, at a $35 strike. As noted in my article on foreign stocks, I now know that I should have purchased the UL shares for Unilever instead of the UN shares, to avoid the 15% tax withholding imposed by the Netherlands. I will let the shares go if assignment threatens, and buy back as UL when a buying opportunity subsequently appears.
First Energy - I successfully bought the shares back using a January 2012 near-the-money put sale, with a strike of $43, and I have since sold another covered call, with expiration in July 2012, at a $45 strike. This was the first time I had ever tried this acquisition approach, which worked, amazingly.
NuStar Energy - After being out of the stock as it remained in the stratosphere for several months, I re-purchased the stock in three increments, beginning in November 2011, and concluding in February 2012, bringing my holdings up to 100 shares, at an average cost of $55.92. As the stock has advanced above $60 in recent days, I have been attempting to sell a covered call at a strike of $65, which so far has not been filled. Based on my history with NS, I won't be dropping to a lower strike - I'll just wait it out until I either get filled, or abandon the attempt. If NS drops back down, I will pass on selling a call on NS, at least for the time being.
In conclusion, I do believe that selective covered call selling is a viable strategy, to increase returns on dividend stocks. The experience with NuStar Energy as presented was an outlier, and is not typical of what I have experienced. I included it to present a worst-case scenario, just to illustrate what can happen, not to frighten readers away from the strategy. As long as the option seller has the resources and the temperament to accept the obligations that come with being on the short side of an option contract, and is prepared to accept whatever comes, either by accepting assignment, or by purchasing back the sold option, the strategy can be used successfully to enhance returns.
Additional disclosure: As noted in the article, I also have sold call options against my positions in UN and FE, and I am in the process of attempting to sell a call against my position in NS.