Covered Calls: Selecting The Strike And Expiration

Includes: MMM
by: Tom Armistead

In addition to the ongoing question of whether selling covered calls increases returns, an associated question relates to the proper strike and expiration of the calls sold. Many writers recommend selling at the money or first out of the money calls (OTM) on a monthly basis. The thinking is, time decay is at its most rapid during that time.

However, selling distant expiration 2nd or 3rd OTM calls, and rolling the positions every 90 days, may provide superior results. This article explores the reasoning behind that assertion, then goes on to discuss whether now is a good time to sell covered calls.

Please consider the following options chain, from earlier this month:

3M (NYSE:MMM) Share Price $87.54




April - 40 days to expiration

MMM APR 21 2012 90.0 Call



MMM APR 21 2012 92.5 Call



MMM APR 21 2012 95.0 Call



July - 131 days to expiration

MMM JUL 21 2012 90.0 Call



MMM JUL 21 2012 92.5 Call



MMM JUL 21 2012 95.0 Call



October - 222 days to expiration

MMM OCT 20 2012 90.0 Call



MMM OCT 20 2012 92.5 Call



MMM OCT 20 2012 95.0 Call



The April 90.0 call earns 67 cents/40 days X 365 days = $6.11 annualized on a pro rata basis. In practice, the evidence shows that this strategy will perform on a par with the market, but with less volatility. Because the call will be exercised repetitiously, the investor will be paying taxes on short-term capital gains and may lose income because of a dividend capture strategy. He will receive very little share price appreciation.

Selling the Oct 95 call, and planning to roll it 90 days later, if the share price and implied volatility are unchanged, time decay will amount to $1.19, based on the price differential between July and October at the bid. Annualized, on a pro rata basis, that works out to $4.77. As a percentage of the share price, it comes to 5.4%, which is a nice supplement for the dividend, currently 2.72%.

If called away, the annualized return is 17.8%. Noting that the consensus target per FinViz is $95.41, the investor will have sold the stock slightly above the target price, if you add in the premium received.

Not shown, I experimented with Johnson & Johnson (NYSE:JNJ), Procter & Gamble (NYSE:PG) and Colgate-Palmolive (NYSE:CL), and was able to produce trades that were comparable, in that the returns exceeded the dividend and the sale price if called away was in the area of the consensus target.

I think this is a more useful way of thinking about the covered call strategy, especially for the dividend growth or buy and hold investor. Trading costs will be reduced, dividend capture will occur less often, and the stock will not be called away as frequently. The tax results will be better, with fewer short term capital gains and fewer sales overall.

I did an article on the covered call strategy early last year, and concluded that a 3% additional annual return would be possible for a carefully implemented program in a relatively stable market. I also found evidence that the sale of distant expirations would outperform monthly at the money. But I was looking at leaving the position alone until expiration. Rolling every 90 days, if successful, should outperform waiting for expiration.

Not Being Greedy

Such evidence as is available suggests the covered call strategy is good for between 0% and 3% annual increase in returns, compared with simple buy and hold investing. If 3% is what is available, the common sense approach is to harvest that amount with a minimum of disruption and trading. Getting back to the 3M example, the MMM Oct 20 2012 97.5 call was selling for $1.40 at the bid, vs. 45 cents for the July call, for a 90 day time decay of 95 cents in the static case. Annualized, that works out to $3.80, or 4.3% of the share price, and still more than the dividend.

Complications will arise. If the share price increases, any concerns the investor may have about being called away at a price 11% above what prevailed when the trade was made are luxury problems. If the shares decline, the call expiring in October still has some time to run, so the investor doesn't have to immediately ponder the implications of selling another call at a strike that will guarantee a loss from the original purchase price.

Over the past 5 years, I've sold covered calls on an ongoing basis, primarily over a portfolio consisting of deep in the money LEAPS. In practice the strategy has its frustrations. At one point, I did a profit and loss analysis and discovered that the buyers of the calls I sold had been amply rewarded. Amply rewarded.

My experience as I interpret it is that a large part of the excess returns that seem to be available with the covered call strategy are illusory. Reaching for 8% or 12% excess returns by selling covered calls too close to the money and too close to expiration will churn your account for perhaps 1% extra if you are lucky.

I've grown comfortable with the more distant expirations, and further out of the money, for the fact that results were better, or at least felt better. I often roll them out, at times when the extra premium seems desirable, or out of a concern (perhaps misplaced) that they are too close to the money. After giving the matter systematic thought, the practice of rolling out to keep expirations around 4 to 7 months in the future makes sense to me, considering that the 90-day decay on strikes that are 8% or more above the share price provides sufficient income to very nicely supplement dividends. If 3% is all you are going to get, why not take the most efficient path to the expected outcome?

Is now a good time to sell covered calls?

The article linked above is over a year old and typically draws 5 page views a day. At the time of this writing it has 28, which I regard as a sign investors are thinking about selling covered calls. After all, the market is putting in new highs, and if it goes down from here, why not collect some premium as a consolation?

Warren Buffett remarked that selling puts will not get you in at the bottom. In a similar vein, selling covered calls will not get you out at the top. The sale of covered calls is not a substitute for taking profits, if you think the market is at a high point and your shares are fully valued.

The VIX has been hitting lows lately, suggesting that premium levels for selling covered calls will not be generous. The problem is, when share prices are high, volatility is often low. At the other end of the spectrum, when share prices are low, volatility is high, tempting the investor to sell calls just before the shares make a large upward move. As a general rule, options should be sold when volatility is high, and bought when it's low.

In September last year, when volatility was high, I sold a fair amount of calls. However, I selected the strikes at levels that were consistent with my view of where the market was going, 1,450 on the S&P 500 at that time. As I noted in my instablog, it was possible to get fairly good premiums for calls that were 20% to 30% above the current market level. Thinking in the same way, although volatility is lower, today the market and most stocks are closer to their fair values, so selling calls 8% or 9% out of the money might make sense.

I sold some today, on a high beta, high implied volatility situation where the stock made a strong move and the premiums were attractive. Not one of my better picks, from where it lies there is good money to be made selling covered calls until it's called away.

If the primary concern is protection from a downdraft, the sale of covered calls provides limited protection, in the amount of the premium received. Some brokers are recommending a stock substitution strategy. An investor who has a profit on his shares, and wants to define his downside risk, can sell the shares and replace them with options. To the extent that volatility is low, it makes this strategy more attractive.

While the major indexes are at new highs, individual stocks vary. According to Morningstar, my portfolio has a price/fair value of 0.89, with the stocks ranging from 0.60 to 1.80 on that metric. The 1.80 is Dunkin Brands (NASDAQ:DNKN), which I am short. There are several other stocks that are above their fair value, most of which have covered calls that are now in the money, and I'm waiting for them to be called away.

After putting all of this through the blender, I still think the sale of covered calls is best done after considering the stocks individually, rather than as a blanket strategy for an entire portfolio. Also, and particularly for investors who lean toward a buy and hold or dividend growth approach, it makes sense to be realistic about the additional returns that are available and not get greedy for premium. After all, the market could go higher, and many individual stocks are still undervalued.

Disclosure: I am long MMM.