Protected Principal Retirement Strategy: Retiring Without A Million-Dollar Nest Egg - Part XI

 |  Includes: PER
by: Akaralph

In the previous 10 articles comprising the Protected Principal Retirement Strategy series, we have discussed a basic approach that might be followed by those of us who do not have a $1 million-plus nest egg (aka mid-rangers). We also suggested a method of allocating our investments, and have spent time and some detail reviewing and analyzing several dividend-paying asset classes.

This article presents a methodology for enhancing the yield of the Protected Principal Retirement portfolio through the use of options. Before advancing this strategy I will state unequivocally that I am not an expert in the area of options, and what I present here is the only strategy that I presently utilize. I welcome suggestions from readers relative to other option strategies that afford equal (or better) opportunities to enhance yield.

From time to time I have noticed some excellent articles on options strategies that have been published on Seeking Alpha, so I will not cover any basic tenets of options trading herein -- other than what is necessary for this specific strategy.

I will provide a reference to one book that I consider to be an excellent reference on options trading (not compensated for making this recommendation -- wish I was). The title of the book is "Options Trading for the Conservative Investor" by Michael C. Thomsett. The book explains things in a way that is easy to understand (if there is such a thing when it comes to options), and it is from this book that I developed the strategy that I presently use.

The Basics

The strategy I use for dividend enhancement is that of writing covered calls against positions that are in the portfolio. I believe that this is a fairly conservative approach to take, and aside from occasionally having stock called away it has added income to my accounts.

Prior to implementing this strategy, I believe it is necessary to have a confident opinion as to where the market is headed, at least for the duration of the options trades that one will make. I use the following principles as guidelines:

  • If one perceives the market as being in a bullish trend, write out-of-the-money covered calls.
  • If one perceives the market as being in a bearish trend, write in-the-money covered calls.
  • If one perceives the market as being in a sideways trend, write at-the-money covered calls.

By it's nature, the Protected Principal Retirement portfolio presents more limited opportunities to utilize this strategy, since a few of our asset classes (closed-end funds, foreign stocks) do not allow for options transactions.

Also, as the portfolio is presently overweighted with MLPs that have been long-term holdings, I do not want to place these holdings in a position where they are likely to be called away and result in an excessive tax bill. So I generally only write out-of-the-money covered calls for this asset class.

We are then left some MLPs, domestic Royalty Trusts, REITs, mREITs and business development companies (NYSEARCA:BDCS) with which to work. Aside from the mREITs, these stocks are not the most volatile, and therefore do not generate large option premiums.


The tax consequences of writing covered calls varies depending on if one writes in-the-money, at-the-money, or out-of-the-money calls. Without getting into a lot of detail (not the purpose of this article) on taxes, suffice it to say that writing out-of-the-money covered calls offers the most favorable tax treatment, and writing in-the-money covered calls offers the most complex tax treatment. If you have questions I suggest contacting your accountant or tax preparer.

Strategy Implementation

In order to make the writing of covered calls worthwhile and tax-advantaged, this strategy looks for out-of-the-money covered calls where the strike price is at least 5% above the current stock price, where the expiration date is a minimum of two months distant (and perhaps more), and the premium to be received from selling the call is at least 2% of the underlying stock price. It is also recommended to not write covered calls unless one has a profit in the underlying stock. These criteria are not hard and fast but will eliminate some bad trades. There are also many options calculators online that will do a lot of the research and math for you, including Optionetics on Yahoo, among others.

Writing covered calls on higher yielding stocks always carries with it the risk that the stock might be called away early in order to capture the dividend. It is a particular risk with MLPs. This is another good reason to focus on out-of-the-money covered calls. The use of Long-Term Equity Anticipation Securities (LEAPs) should also be considered as a part of this strategy. LEAPs are option contracts that have an expiration date at least 12 months distant. They usually offer a higher premium as there is a longer inherent time value.

Let's use Sandridge Permian Trust (NYSE:PER) as an example. Let's say we own 100 shares of PER in the portfolio. It is currently trading at $19.44 and we are bullish on oil prices going forward. We note that the last trade on the January 2013 $20 calls is $1.00. This equates to a premium of just over 5% of the value of the underlying stock. We would net $100 by selling one January 2013 $20 call, giving us downside protection on our PER stock to $18.44. Of course the risk here is that in November PER will declare its quarterly dividend, which should be in the range of $0.60 +/-. So, if the stock price remains close to, or exceeds, the $20 level by November, the stock could be called away prior to the option expiration date of Jan. 18, 2013. If it does get called we would lose the November dividend, but retain our $1.00 premium and receive $20 a share for the stock. Our net gain would be about 8% ($1.00 + $.56 profit on PER stock/$19.44).

Now, suppose we get close to November and the PER stock price is hovering around $20 a share. We anticipate that PER will be paying at least a $.60 a share dividend and we would like to insure that we keep the stock. We have three options: We can "roll" our options forward, we can "roll" them up, or we can "roll" them forward and up. Let me explain:

  • Rolling forward involves buying back our January 2013 $20 call and selling a new call that has the same strike price but expires at a later date.
  • Rolling up involves buying back our January 2013 $20 call and selling a new call that expires at the same time but at a higher price.
  • Rolling forward and up involves buying back our January 2013 $20 call and selling a new call expiring later than the old one and at a higher price. It is frequently possible to execute a forward and up roll and still produce a net credit, and thus this is to most desirable of the three alternative methods of rolling. In addition, by closing out the original position you can generate a current year loss for tax purposes.

In our PER example, just rolling forward would not insure that we would retain our PER stock through the November dividend payment. Both rolling up and rolling forward and up would probably enable us to retain ownership of PER while securing the November dividend.

As I mentioned earlier in this article, this is but one strategy for enhancing our portfolio's yield -- and it might not be the best. I do believe that it is one of the more conservative options strategies available to us. Like anything else in the investment realm, the more research one does, the greater the reward.

In the next article we will conclude this series. It is my intention to put together what we have discussed, integrate some of the more substantive comments that have been received, and come up with a completed allocation strategy for the Protected Principal Retirement portfolio. Readers might want to go back and review Part I, Part II, and Part III as it will help in the assembling of our ideas.

Subsequent to the final article, it will be my intention to provide a discussion from time to time of one or more of the specific portfolio stocks.

Disclosure: None of the stocks or funds mentioned in these articles constitute buy or sell recommendations. I personally own a small position in PER. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.