One useful strategy for boosting your investment returns is the selling of covered call options. Knowledge of this strategy can be especially useful for investors who need to generate income off of their investments to cover daily expenses. This strategy can make non-dividend paying stocks much more appealing to those individuals as it allows them to earn a synthetic dividend off of these companies. Additionally, the strategy can be used to artificially boost the dividend payout from a company that is already paying dividends.
One offshore drilling company that this technique can be used with is Transocean (RIG). The company proposed canceling its dividend during the most recent conference call in a move to conserve cash and protect its credit rating. Thus, at present, the company's stock is trading as a non-dividend paying stock. Call options provide us with the opportunity to artificially turn Transocean into a dividend stock though.
For the purposes of explaining how an investor would use this strategy to produce synthetic dividends, I will provide an example. At the time of writing, Transocean stock sells for $49.14 per share. Call option contracts with maturity dates of April 2012, May 2012, August 2012, November 2012, January 2013, and January 2014 are available on the market. The option to sell depends on each individual's own goals or needs. Generally, options with later maturities carry higher price tags (in this case that would mean that the synthetic dividends will be larger but less frequent), but also carry a higher risk of being exercised (since the stock has more time to reach the strike price). For the purposes of this example, we will assume the sale of the August 2012 call option.
As previously stated, the closing price of Transocean stock on April 11 was $49.14. Let's assume that a hypothetical investor buys 1,000 shares at this price for a total cost of $49,140. This investor wants to sell options against the entire 1,000 share block. Here are the prices for the RIG August 2012 call option at a variety of strike prices.
Source: Yahoo! Finance
The investor decides to sell the option with a $60 strike price. Since this investor wants to sell options against the entire block of shares, ten option contracts (since each contract represents 100 shares) would need to be sold. This will produce $1,390 in immediate income to the investor. There are a few ways that this could play out on the August maturity date.
Scenario 1: Stock Price Between $49.14 and $60 on Option Expiration Date
In this case, the buyers of the option contracts will not choose to exercise their options. The options will be allowed to expire worthless. The hypothetical investor will keep the option premium as well as ownership of the stock. This scenario would give the investor a return of $1390 or 2.83% over the five-month period (excluding any paper gains on the stock). This works out to an annualized return of 8.283%.
Scenario 2: Stock Price Greater than $60 on Option Expiration Date
In this case, the buyers of the option contracts will choose to exercise their options. This is the only of the three scenarios in which the hypothetical investor will not be left holding the stock following the option expiration date. The investor's total return in this scenario would be the option premium plus the difference between the stock purchase price and the $60 option strike price. Thus, the investor would have a total return of $12,250 or 24.9% over the five-month period. This works out to an annualized return of 88.518%.
Scenario 3: Stock Price Less Than $49.14 on Option Expiration Date
In this case, the buyers of the option contracts will not choose to exercise their options. The options will be allowed to expire worthless. The hypothetical investor will keep the option premium and retain ownership of the stock. This is the only scenario in which a paper loss is possible. This will occur if the stock declines by more than the option premium that was received. The paper loss could turn into a realized loss if our hypothetical investor were to sell the stock at this point. Essentially, it would act like an ordinary long position with one difference: The sale of the covered call artificially lowers the investor's cost basis. Thus, any loss is lower than it would be without the sale of the covered call. This is similar to the way a dividend would affect the total return and so the option premium can be considered a synthetic dividend. The synthetic dividend in this case would be the option premium, equating to an annualized yield of 8.283% based on the initial purchase price.