The Typical Covered Call:
Many investors sell covered calls on low-beta dividend paying stocks. This helps to enhance the return of long positions by providing additional income. They often sell these calls with the strikes "out of the money". This reduces the chance their shares will be called away, however, it also drastically reduces the protection AND income that selling calls can offer. To make matters worse, these low-beta stocks have low implied-volatility which reduces premium intake.
An Underestimated Alternative:
Use a stock with high beta and supporting fundamentals. This may sound contradicting, but the combination does in fact exist. Also, sell an "in the money" strike. The resulting balance of premium income and protection is advantageous and often overlooked.
I selected Sandridge Energy (SD) for several reasons:
1) A solid recent earnings report, as well as impressive production results (click to see the investor presentation from Aug 8, '12 )
2) A High Beta (volatility) of almost 3 as per Yahoo Finance. This will increase the premium we can collect when selling the call.
3) Well known upside potential and big promises from management to grow revenues. This attracts many buyers for the calls we can sell.
The Covered Call:
A high degree of protection with decent income is what I am looking for. I chose the Jan 2013 6.0 Strike, Premium at 1.22, while buying 100 shares at 6.65. Prices are as of 8/28/12.
So What's the Risk/Reward?
-Our Max gain is 8.5%, secured by a cushion of 9.7%
-This 8.5% gain starts to get reduced below the 6/share level, or a 9.7% drop in share price.
-5.43/share is our Break Even Point, a whopping 18% below our initial 6.65/share purchase. This offers tremendous protection to us in this trade.
This diagram may help:
If shares trade anywhere above 6.00, we reap the full reward of 8.57%. In fact, as much as a 9.7% drop in share price would still result in the full 8.57% profit. Annualized, this amounts to about a 20% gain. But wait, it gets better...
If shares were to drop 15% (yellow range) we would still turn a small profit.
At times, selling covered calls on slow moving dividend stocks can be a rather lame endeavor. We instead chose a high beta stock with decent fundamentals, then sold a high paying "in the money" call. In my opinion, this situation offers an attractive risk/reward profile and presents a compelling addition to my balanced portfolio.
Additional disclosure: I have covered call options on this position. The positions mentioned in this article are not for everyone, as we all have our own investment goals and risk tolerances. Ultimately, you must make your own investment decisions.