A Closer Look At A Hybrid Dividends And Covered Call Strategy

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 |  Includes: AAPL, INTC, RL
by: SA Editor Rocco Pendola

Earlier this week, I wrote an article, What's Better? Dividends Or Covered Calls. As I noted in the comment section of that article, I regret my choice of words for the title. While it was not my intention, it seems that I set up a dichotomy between the two sources of income.

To clarify, I do not consider the comparison an either/or type of situation or a battle between which one is better. Unfortunate wording on my part because it certainly did come across that way. In this article, I illustrate how dividends and covered calls can work together and possibly enhance performance in growth and income portfolios.

When I refer to dividends and covered calls, I do so within the context of an investment portfolio with a long-term time horizon. As such, I can just as easily and accurately call dividends, dividend reinvestment. And, on covered calls, while some trades might end up triggering short-term capital gains, the consistent goal is to use covered calls in a way that's not all that different from how many investors use dividends.

Taxes

I will not factor taxes into the equation. I made this choice for several reasons. First, we all have different circumstances. Some investors reinvest dividends and use covered calls in an IRA. Of those folks, a few are in traditional IRAs, while others employ Roth IRAs.

Other investors use taxable investment accounts. But, again, various situations come into play. I'm self-employed. My wife works as a salary slave. We rent and take the standard deduction, but I write off quite a few business expenses. That puts us in a completely different place than the homeowner couple that sees both spouses out in the traditional workforce with little more to deduct than mortgage interest. And, of course, plenty of people come in on either side of and in between both examples.

Additionally, fellow Seeking Alpha contributor Jim Fink makes the case that, with respect to covered calls, tax implications should not scare you away:

To be fair, covered calls typically generate a greater frequency of taxable gains and losses than a long-only strategy, so it is clearly preferable to sell covered calls on stocks held in a tax-deferred retirement account ...

Not only does the sale of covered calls create frequent taxable gains, but there's also always the risk of early exercise, which would require you to sell the underlying stock. Selling stocks that have very low cost bases because they were bought a long time ago and have since appreciated in value can be especially problematic because their sale could trigger substantial capital gains taxes.

Nonetheless, the potential benefits of covered calls far outweigh the tax implications.

We will discuss some of the benefits in this article. I could make a similar argument in relation to dividends in a taxable account.

Time

As Fink notes:

Remember, writing covered calls is not a sell-and-forget strategy, but one that requires monitoring. Given the impressive outperformance covered calls have generated over time, however, the small degree of monitoring that is required is well worth it.

No question, you can basically put dividend reinvestment on auto-pilot, however, when you write covered calls you need to (a) put considerable thought into the contracts you select and (b) mind the position so you can react to the potential outcomes.

Practically speaking, if you're the type of investor who obsessively checks his or her portfolio, it's great to have something in there that's worth looking at. Having a series of covered call positions to attend to might just stop you from over-trading straight positions. And, as Fink points out, a buy/write strategy can outperform the broader market:

A new study by Asset Consulting Group, covering the period between June 1988 and December 2011, underscores the superiority of covered calls over a simple buy-and-hold strategy.

ACG's study compares the S&P 500's return with the return of two S&P 500 buy/write indexes: the CBOE S&P 500 BuyWrite Index, which sells S&P 500 covered calls every month at strike prices "at the money" (i.e., the same price as the underlying index); and the CBOE S&P 500 2% OTM BuyWrite Index, which sells covered calls every month at strikes 2 percent above the price of the underlying index ...

Both S&P 500 buy/write indexes beat the S&P 500 index while incurring less volatility-the best of both worlds. Consider that the S&P 500 rose 360 percent during this 23.5-year period, from 273.50 at the end of June 1988 to 1257.60 by the end of December 2011, and yet a covered-call strategy that generated monthly income in exchange for capping monthly gains still outperformed a long-only S&P 500 portfolio.

Of course, it's a bit unfair to compare indices like this. While you could always just go long the aforementioned indexes, most people will not. Instead, you have your own mix of stocks you'll write covered calls against and reinvest dividends on. That said, I agree with Fink. This style of what amounts to active management holds great potential to provide superior results compared to a more passive buy-and-hold approach.

The Best Of Both Worlds Times Two

A few readers take exception to my categorization of covered call premiums as a "source of income," similar to dividends. Here's one of the better counter cases:

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With all due respect, that comment helps illustrate why most options information throws new options investors for a loop. It's because of these types of comments that people either run away from options or, worse yet, get into trouble. It's often difficult to understand something like that after you've had experience with options, let alone when you're just starting out. That's why I write these articles and publish my newsletter. We need to cut through technical lingo, focus on basic and practical information and start thinking of options with the mind of a long-term investor, not a trader.

Within the context of this discussion - using dividend reinvestment and covered calls to generate income and boost returns - the discussion of volatility has little practical application. Certainly it matters. It's nice to know the basic tenet that generally you'll collect a larger premium when implied volatility is high. That tends to occur ahead of major events such as earnings. It's also nice to know that once the event takes place, implied volatility often tanks, sucking the value out of an option premium. That's exactly why you can pick the correct direction ahead of earnings, but still lose on an options trade held through the event.

That's practical knowledge. And, if you only intend to take a conservative approach to options (e.g., writing covered calls for income), you really do not need to know much more than that.

In these discussions, we concern ourselves way too much with the "risks" of covered call writing and the premium we will collect. If you're long a stock - as in, it's a buy-and-hold long-term investment - who really cares if you get $0.50 or $0.35 for the premium? I know I don't. It matters to me as much as I care about whether Intel (INTC) raises its dividend to $0.87 and $0.88.

All that really matters is that you squeeze extra income out of your position. It will all even out in the end. Sometimes you will get a great premium. Sometimes you'll get a wimpy one. No reason in the world exists to concern yourself over the size of the premium when, and I stress, you use covered calls as part of a long-term plan for generating income, not as a trading tool.

In my newsletter each week, I present what I call high-implied volatility covered call ideas. The parameters around these trades - and they are trades - are as follows:

  • We want to take advantage of juiced-up premiums.
  • We want our stock to get called away.
  • However, in case the stock dives, we need to make sure it's a company we would not mind holding, and even adding to, over the long-term.

In this situation, you might sell a Ralph Lauren (RL) $180 May call, collecting $4.50, on the stock when it trades for $177.82. In this trade, 100 shares sets you back $17,782. If you get your shares called away at $180, you take in $18,000 in proceeds. On the stock trade, that's a 1.2% gain. Not so good for a six-week hold. However, when you factor in the covered call income received, your return jumps to 3.8%.

On the downside, you've protected yourself all the way to $173.32. This trade does not start losing money until RL dips below that point. As such, you could close the trade with RL trading above $173.32, but below your stock entry price of $177.82 and still make money thanks to the $4.50 premium you received.

That's an example of a short-term trade where implied volatility clearly matters. Within the framework of a long-term growth and income portfolio, however, you do not have to concern yourself, as much, with IV and premiums.

Let's consider an example of how investors can execute a hybrid dividend/covered call strategy. First, I address the so-called "risks" associated with covered calls. The stock tanks. Newsflash: The covered call did not make your stock tank. It's a long-term conviction holding, presumably, in a long-term growth and income portfolio, presumably, it could tank whether or not you have covered calls written against the position.

The stock soars. You get your shares called away. I don't see how people can quantify or qualify this as a "risk." We'll use Apple (AAPL) as the example because it now pays a dividend and it's become the stock that people like to talk about. You own 400 shares of AAPL. You have a cost basis of $380. The stock trades for $628. You really do not want to lose your shares so, today, you take what I classify as an ultra-conservative approach to covered call writing. Here's what you do:

  • Write 1 AAPL April $680 call and collect $1.32 in premium. AAPL needs to pop about 8.3% over less than two weeks and/or at expiration for you to get your shares called away.
  • Write 1 AAPL May $750 call and collect $2.84 in premium. AAPL needs to jump 19.4% between now and May expiration for you to get your shares called away.
  • Write 1 AAPL June $805 call and collect $2.47 in premium. AAPL needs to appreciate by 28.2% between now and June expiration for you to get your shares called away.
  • Write 1 AAPL July $860 call and collect $2.43 in premium. AAPL needs to soar 37.0% between now and July expiration for you to get your shares called away.

No matter what happens, you've collected $906 in income. Now, remember, this is an incredibly conservative strategy. Get more aggressive and you're easily into the thousands. I will not even calculate how well you could do if you wrote new calls for the remainder of the year as each one expires worthless. April expires, you write May. May expires, you write June ... and so on.

But, what if your calls do not expire worthless? What if your shares get called away? It's scary to think that you capped your gains at 78.9%, 97.4%, 111.8% and 126.3%, respectively (using a $38 cost basis), in the above-mentioned April, May, June and July examples. Don't worry, the local food bank is well-stocked and ready for you. No questions asked. Come as you are.

Let's not forget, you'll also collect two AAPL dividend payments this year for a total of $2,120 on 400 shares. Sweet. If you reinvest those dividends at an average price of $800 per share, you now own 402.65 shares of AAPL.

Right now, I have an April $29 call written against 100 shares of INTC. I have a cost basis of $27.92 on the stock. While it's small potatoes on a monthly basis, the $0.23 I collected adds up throughout the course of the year and acts like more than another annual dividend payment. If I lose my shares at some point and want them back, I can just write a cash-secured put to make it happen. I collect income using that strategy as well.

A commenter to the previous article on this subject summarized one of the major keys to all of this:

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Endpoint: If you want to make this options stuff more complicated than it needs to be, go right ahead. However, if you're a long-term investor who wants a reason to mind his or her positions on a regular basis and you wish to generate a little more income in your portfolio, keep it simple, stick to the basics and everything should work out fine, provided you pick great stocks and cut through the noise.

Disclosure: I am long INTC. I am short an INTC April $29 call.