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"We all live amid surfaces, and the true art is to skate well on them."

Ralph Waldo Emerson

The covered call strategy is a great way to open a second stream of income and minimize the impact of volatile gyrations on one's portfolio.

What are covered calls?

An investor basically writes a call option (sells calls) that are backed by the equivalent number of shares, hence the name covered call. If the stock is purchased at the same time a call contract is sold it's often referred to as a "buy write." On the other hand, if the shares are already from a previous purchase, it is referred to as "overwrite." This is the most basic and widely used strategy, which combines the litheness of options with stock ownership.

When you write a covered call income is generated in the form of the premium paid by the option buyer. If the stock trades above the strike price, then the owner will have to sell the shares at that price, if not the owner of the stock gets to keep the premium. The risk of stock ownership is not eliminated. If the stock drops significantly, then the net position will likely lose money. However, using this strategy would reduce the loss factor by the amount in premiums the owner of the shares received for each call he sold. The main risk of a covered call strategy is that the stock might decline significantly in value. In other words, the same risk any shareholder bears but with the added benefit of receiving a premium for the calls you sold.

Let us look at an example

Let's say you own 300 shares in stock X which is currently trading at 40, and you think that there is little chance that the stock is going to hit 45 in the next six months. You can then sell calls with a strike of 45. The premium you receive is yours to keep. If in the next six months it does not trade above 45, then you hold onto the shares as well as the premium.

Benefits of employing this strategy

Income generation

Each contract trades at a premium (the higher the beta the higher the premium), and the buyer of the contract pays you that premium for the right to purchase 100 shares of the stock at the strike price. The premium is deposited immediately into your brokerage account.

Downside protection and reduction in portfolio volatility

If the stock drops in value, the premium collected at least some type of return, and it can offset all or part of the loss depending on how severely the stock has pulled back. For example; if you sold a covered call against a stock when it was trading $20 for a premium of $2.50, then as long as the stock does not drop below $17.50 you are OK. In essence, you have reduced your entry price to $17.50. If this strategy is actively employed, then you could in general significantly reduce the volatility your portfolio is subjected to.

Predetermined rate of return

This strategy gives you a decent idea of what your rate of return on your investment will be. Regardless of what takes place you still get to keep the premium. If your shares are called away from you at the strike price, it is easy to figure your profit. This is the difference from what you paid for the stock and the strike price you sold the option, plus the premium you collected. So let's take the above example. If SeaDrill (NYSE:SDRL) trades above 45, your shares are called, and you are out at 45. So your profit is 7 plus the 2.50 which you received in premium for a total gain of 25%.

If the stock starts to drop in price, you lose money on paper (much like any other shareholder) when the price of the stock falls in excess of the premium you received.

Converts a common stock into a dividend paying stock

The moment you sell the call option, the stock you own, in essence, has turned into a dividend paying-stock. If it already pays a dividend you have turbo charged your gains.

Repeat the process all over again

If your shares have not been called away from you, you can repeat the whole process again with the same shares of stock you own. Utilized properly this strategy can produce an income stream that can surpass the dividend paid out by that specific stock. If the stock does not pay out a dividend, you have just converted into one that does. If the stock is called, there is nothing to prevent you from buying another good stock and repeating the whole process again.

Buy back the call

If you sold the call for a premium of 2.50 and the call is now trading at 1.00, you could buy the call back, and you still get to keep the difference, which in this case amounts to $1.50. You could take things one step further and start the whole process again by selling calls that are fetching higher premiums. For example, you sold calls on stock X when it was trading at 37 with a strike at 40 for a premium of $2.50. The stock is now trading at 34, so you buy the call back and sell new calls with a strike at 37.50.

Novartis AG Common Stock (NYSE:NVS) is our play of choice for the following reasons:

  • A massive levered free cash flow of $11.5 billion.
  • Net income has increased from $8.4 billion in 2009 to $9.13 billion in 2011.
  • EBITDA has increased from $10.47 billion in 2009 to $11.5 billion in 2011.
  • Cash flow per share has increased from $3.72 in 2009 to $5.52 in 2011.
  • Annual EPS before NRI has increased from $2.81 in 2007 to $5.57 in 2011.
  • It sports a good ROE of 20%.
  • A 5 year sales growth of 10.5%.
  • A very good long term debt to equity ratio of 0.21.
  • It has a decent current ratio of 1.04; a weak quick ratio of 0.78 but this is shortfall is made up for by a good interest coverage ratio of 8.25.
  • A very low payout ratio of only 36% and a great 5 year average payout ratio of 34%.
  • It sports a very strong 3 and 5 year dividend growth rate of 13% and 18% respectively.
  • It has a decent 3 year total return of 61%.
  • It has respectable free cash flow yield of almost 10%.
  • 100K invested for 10 years would have grown to 190K; if the dividends were reinvested the rate of return would have been much higher. The rate of return could have also been turbocharged via the selling of covered calls.

Now for the covered call strategy on Novartis

Novartis ended yesterday at 55.39 and faces a fairly strong amount of resistance in the 60 ranges. Investors could thus sell the Oct 60 calls; the current bid is $1.00 and the ask is $1.10. Lets assume a sell price of $1.05.

Once you sell the calls $1.05 per share is deposited in your account. Each contract covers 100 shares so you need to have at least 100 shares to put this strategy to use. If the stock trades past 60 then your shares will be called and you will be paid 60 per share. Your total gain will be roughly $5 plus the $1.05 you were paid per call for a gain of 10.98%. If the stock does not trade above 60 then you get to keep the premium of $1.05. If your shares are called you still walk away with a nice gain and there is nothing to stop you from implementing the whole process again.

Other variations for more aggressive players

Another option is to buy the call back if it drops significantly. Let's say the call drops from $1.05 to 30 cents then one could purchase the call back and then start the whole process again. For example if the stock has dropped from down to 61 one could sell calls that command higher premiums.

Novartis AG Common Stock NYSE: NVS

Industry: Pharmaceuticals

Levered Free Cash Flow: 11.52B

Growth

  1. Net income for the past three years
  2. Net Income 2009 = $8400 million
  3. Net Income 2010 = $9794 million
  4. Net Income 2011 = $9113 million
  1. EBITDA 12/2011 = $11524 million
  2. EBITDA 12/2010 = $12394 million
  3. EBITDA 12/2009 = $10473 million
  4. Net income Reported Quarterly = $1175 million
  1. Total cash flow from operating activities
  2. 2008 = $9.67 billion
  3. 2009 = $12.2 billion
  4. 2010 = $14.07 billion
  1. Cash Flow 12/2011 = 5.52 $/share
  2. Cash Flow 12/2010 = 5.25 $/share
  3. Cash Flow 12/2009 = 3.72 $/share
  1. Annual EPS before NRI 12/2011 = 5.57
  2. Annual EPS before NRI 12/2010 = 5.13
  3. Annual EPS before NRI 12/2009 = 3.7
  4. Annual EPS before NRI 12/2008 = 3.59
  5. Annual EPS before NRI 12/2007 = 2.81

Performance

  1. ROE = 20.1%
  2. Return on Assets = 10.81%
  3. Quarterly Earnings Growth = -45.8%
  4. Quarterly Revenue Growth = 3.7%
  1. Price to Sales = 2.27
  2. Price to Book = 2.02
  3. Price to Tangible Book = 33.82
  4. Price to Cash Flow = 10.02
  5. Price to Free Cash Flow = 23
  1. Current Ratio 09/2011 = 1.04
  2. Current Ratio 5 Year Average = 1.41
  3. Quick Ratio = 0.78
  4. Cash Ratio = 0.34
  5. Interest Coverage 09/2011 = 8.25
  6. Total return last 3 years = 61.29%
  7. Total return last 5 years = 14.29%

Dividend sustainability and history

  1. Payout Ratio 09/2011 = 0.36
  2. Payout Ratio 06/2011 = 0.37
  3. Payout Ratio 5 Year average 09/2011 = 0.34
  4. Payout Ratio 5 Year average 06/2011 = 0.33
  5. Change in Payout Ratio = 0.02
  1. Dividend yield 5 year average = 4%
  2. Dividend growth rate 3 year average = 13.01%
  3. Dividend growth rate 5 year average = 18.15%
  4. Consecutive dividend increases = 5 years
  5. Paying dividends since = 1992

Aircastle Ltd. (NYSE:AYR)

Industry: Construction Services

Levered Free Cash Flow: -142.11M

Growth

  1. Net income for the past three years
  2. Net Income 2009 = $102 million
  3. Net Income 2010 = $66 million
  4. Net Income 2011 = $124 million
  1. EBITDA 12/2011 = $610 million
  2. EBITDA 12/2010 = $506 million
  3. EBITDA 12/2009 = $514 million
  4. Net income Reported Quarterly = $118 million
  1. Total cash flow from operating activities
  2. 2009 = $327.65 million
  3. 2010 = $356.53 million
  4. 2011 = $359.38 million
  1. Cash Flow 12/2011 = 5.17 $/share
  2. Cash Flow 12/2010 = 4.06 $/share
  3. Cash Flow 12/2009 = 4.26 $/share
  1. Annual EPS before NRI 12/2011 = 1.32
  2. Annual EPS before NRI 12/2010 = 0.85
  3. Annual EPS before NRI 12/2009 = 1.32
  4. Annual EPS before NRI 12/2008 = 1.94
  5. Annual EPS before NRI 12/2007 = 1.7

Performance

  1. ROE = 7.27%
  2. Return on Assets = 2.01%
  3. Quarterly Earnings Growth = 76.1%
  4. Quarterly Revenue Growth = 13%
  1. Price to Sales = 1.5
  2. Price to Book = 0.65
  3. Price to Tangible Book = 0.65
  4. Price to Cash Flow = 2.42
  5. Price to Free Cash Flow = -1.6
  1. Current Ratio 09/2011 = 6.23
  2. Current Ratio 5 Year Average = 4.54
  3. Quick Ratio = 6.23
  4. Cash Ratio = 6.19
  5. Interest Coverage 09/2011 = 1.7
  6. Total return last 3 years = 164.57%
  7. Total return last 5 years = -53.18%

Dividend sustainability and history

  1. Payout Ratio 09/2011 = 0.45
  2. Payout Ratio 06/2011 = 0.46
  3. Payout Ratio 5 Year Average 09/2011 = 0.6
  4. Payout Ratio 5 Year Average 06/2011 = 0.61
  5. Change in Payout Ratio = -0.15
  1. Dividend yield 5 year average = 8.9%
  2. Dividend growth rate 3 year Average = 3.19%
  3. Dividend growth rate 5 year average = 46.44%
  4. Consecutive dividend increases = 1 years
  5. Paying dividends since = 2006

Notes

It would fall under the category of "good."

Ashford Hospitality Trust Inc (NYSE:AHT)

Industry: REITs

Levered Free Cash Flow: 215.80M

Growth

  1. Net income for the past three years
  2. Net Income 2009 = $-250 million
  3. Net Income 2010 = $-52 million
  4. Net Income 2011 = $2 million
  1. EBITDA 12/2011 = $285 million
  2. EBITDA 12/2010 = $224 million
  3. EBITDA 12/2009 = $108 million
  4. Net income Reported Quarterly = $118 million
  1. Total cash flow from operating activities
  2. 2009 = $65.62 million
  3. 2010 = $82.65 million
  4. 2011 = $74.6 million
  1. Cash Flow 12/2011 = 2.89 $/share
  2. Cash Flow 12/2010 = 2.07 $/share
  3. Cash Flow 12/2009 = 2.97 $/share
  1. Annual EPS before NRI 12/2011 = 1.86
  2. Annual EPS before NRI 12/2010 = 1.5
  3. Annual EPS before NRI 12/2009 = 1.12
  4. Annual EPS before NRI 12/2008 = 1.31
  5. Annual EPS before NRI 12/2007 = 1.28

Performance

  1. ROE = 5.31%
  2. Return on Assets = 1.36%
  3. Quarterly Revenue Growth = 14.9%
  1. Key Ratios
  2. Price to Sales = 0.72
  3. Price to Book = 0.65
  4. Price to Tangible Book = 0.66
  5. Price to Cash Flow = 3.27
  6. Price to Free Cash Flow = 7
  1. Current Ratio 09/2011 = 0.14
  2. Current Ratio 5 Year Average = 2.93
  3. Quick Ratio = 0.14
  4. Cash Ratio = 0.11
  5. Interest Coverage 09/2011 = 0.58
  6. Total return last 3 years = 549.01%
  7. Total return last 5 years = -11.09%

Dividend sustainability and history

  1. Payout Ratio 09/2011 = 0.21
  2. Payout Ratio 06/2011 = 0.22
  3. Payout Ratio 5 Year Average 09/2011 = 0.28
  4. Payout Ratio 5 Year Average 06/2011 = 0.3
  5. Change in Payout Ratio = -0.07

Notes

It would fall under the category of "good" but with a caveat; only individuals willing to take on a bit of risk should consider this play.

Banco Bilbao Vizcaya Argentaria (NYSE:BBVA)

Industry: Banking

Growth

  1. Net income for the past three years
  2. Net Income 2009 = $6408 million
  3. Net Income 2010 = $6633 million
  4. Net Income 2011 = $4854 million
  1. EBITDA 12/2011 = $12064 million
  2. EBITDA 12/2010 = $13738 million
  3. EBITDA 12/2009 = $14647 million
  4. Net income Reported Quarterly = $118 million
  1. Total cash flow from operating activities
  2. 2008 = $-2808.13 million
  3. 2009 = $3.69 billion
  4. 2010 = $11.41 billion
  1. Cash Flow 12/2011 = 1.31 $/share
  2. Cash Flow 12/2010 = 1.64 $/share
  3. Cash Flow 12/2009 = 2.27 $/share
  1. Annual EPS before NRI 12/2011 = 1.12
  2. Annual EPS before NRI 12/2010 = 1.61
  3. Annual EPS before NRI 12/2009 = 1.93
  4. Annual EPS before NRI 12/2008 = 2.88
  5. Annual EPS before NRI 12/2007 = 2.33

Performance

  1. ROE = 11.7%
  2. Return on Assets = 0.79%
  3. Quarterly Revenue Growth = 7.8%
  1. Price to Sales = 0.83
  2. Price to Book = 0.73
  3. Price to Tangible Book = 0.95
  4. Price to Cash Flow = 6.31
  5. Price to Free Cash Flow = 7
  1. Current Ratio 09/2011 = 1.09
  2. Current Ratio 5 Year Average = 1.55
  3. Quick Ratio = 1.08
  4. Cash Ratio = 0.19
  5. Interest Coverage 09/2011 = 0.9
  6. Total return last 3 years = 32.87%
  7. Total return last 5 years = -49.08%

Dividend sustainability and history

  1. Payout Ratio 09/2011 = 0.36
  2. Payout Ratio 06/2011 = 0.41
  3. Payout Ratio 5 Year Average 09/2011 = 0.28
  4. Payout Ratio 5 Year Average 06/2011 = 0.28
  5. Change in Payout Ratio = 0.08
  1. Dividend yield 5 year average = 7.4%
  2. Dividend growth rate 3 year Average = 13.38%
  3. Paying dividends since = 1990

Notes:

It would fall under the category of "average or below average". There are better plays out there.

Barclays PLC (NYSE:BCS)

Industry: Banking

Levered Free Cash Flow: N/A

Growth

  1. Net income for the past three years
  2. Net Income 2009 = $16110 million
  3. Net Income 2010 = $7033 million
  4. Net Income 2011 = $6339 million
  1. EBITDA 12/2011 = $20021 million
  2. EBITDA 12/2010 = $31270 million
  3. EBITDA 12/2009 = $27575 million
  4. Net income Reported Quarterly = $118 million
  1. Total cash flow from operating activities
  2. 2008 = $48.82 billion
  3. 2009 = $67.58 billion
  4. 2010 = $29.26 billion
  1. Cash Flow 12/2011 = N/A $/share
  2. Cash Flow 12/2010 = 10.25 $/share
  3. Cash Flow 12/2009 = 10.99 $/share
  1. Annual EPS before NRI 12/2011 = 1.54
  2. Annual EPS before NRI 12/2010 = 1.88
  3. Annual EPS before NRI 12/2009 = 5.71
  4. Annual EPS before NRI 12/2008 = 4.36
  5. Annual EPS before NRI 12/2007 = 7.27

Performance

  1. ROE = 7.59%
  2. Return on Assets = 0.32%
  3. Quarterly Earnings Growth = 33.2%
  4. Quarterly Revenue Growth = -2.6%
  1. Price to Sales = 1.04
  2. Price to Book = 0.48
  3. Price to Tangible Book = 0.7
  4. Price to Cash Flow = 1.54
  5. Price to Free Cash Flow = 1.2
  1. Current Ratio 09/2011 = 1.1
  2. Current Ratio 5 Year Average = 1.42
  3. Quick Ratio = 1.1
  4. Cash Ratio = 0.74
  5. Interest Coverage 09/2011 = 0.66
  6. Total return last 3 years = 185.41%
  7. Total return last 5 years = -66.2%

Payout Dividend sustainability and history

  1. Ratio 09/2011 = 0.15
  2. Payout Ratio 06/2011 = 0.13
  1. Dividend yield 5 year average = 11.9%
  2. Dividend growth rate 3 year Average = 12.41%
  3. Dividend growth rate 5 year average = 9.18%
  4. Consecutive dividend increases = 2 years
  5. Paying dividends since = 1990

Notes

It would fall under the category of "average."

Conclusion

The markets are extremely overbought and the prudent path to take would be to wait for a decent pullback before committing large sums of money to this market. In the meantime, long-term investors can use the following two options to open up additional streams of income can consider the following two options; sell covered calls or if you are bullish on the stock sell naked puts. Both these strategies could open up additional streams of income.

EPS, EPS surprise, broker recommendations and price and consensus charts sourced from zacks.com. Free cash flow yield, income from cont operations, and revenue growth sourced from Ycharts.com. A significant portion of the historic data was obtained from zacks.com. Option table sourced from yahoofinance.com.

Source: 5 Covered Call Plays: 2 Great, 1 Good And 2 To Avoid

Additional disclosure: This list of stocks is meant to serve as a starting point. Please do not treat this as a buying list. It is imperative that you do your due diligence and then determine if any of the above plays meet with your risk tolerance levels. The Latin maxim caveat emptor applies-let the buyer beware.