The ex-dividend covered call trade sounds like an overly complex investing tool for your portfolio. Complexity tends to turn people away, but let me assure you that this trade is simple once you master the basics. Stocks that pay dividends have an ex-dividend date. On that date, a declared dividend gets awarded to the holder of the stock. If you buy the stock on the day before it goes ex-dividend, you are entitled to the dividend. The tricky part here is that the market makers for the stock generally drop the price on the ex-dividend date by exactly the amount of the dividend. This gets an investor nowhere if they buy simply for the dividend yield.
Covered call trades help investors to have an additional tool to milk these dividends from the underlying stock. If you pick a call option with a strike price that is close to the current market price, you may be able to have the call option executed at expiration and lock in your buying and selling price before the stock goes ex-dividend. This is a best case scenario, where you capture the dividend and the time value premium of the option. In other cases, the sale of the call option provides the investor with a hedge against the drop in the stock price. The dividend yield may not be fully captured, but cash flow will be retained. A bad scenario in this trade is the stock gets assigned before the ex-dividend date and the trade gets canceled. Generally, you may only lose your commissions paid if this is the case.
With all covered calls, there is also the risk that the underlying stock would fall well below the break-even price. This is the same risk taken by every common stock investor. However, by selling call options against these shares, you are actually increasing cash flow and offsetting any potential losses.
Currently, Compass Diversified Holdings (NYSE:CODI) and Teekay Offshore Partners LP (NYSE:TOO) present an opportunity to trade ex-dividend dates with covered calls. Each of these stocks has a annualized dividend yield over 7%, which is substantially than double the yield of a ten-year Treasury bond. Each also trades with options, which gives additional benefits to the ex-dividend investor. Both stocks go ex-dividend on October 22nd, which means you must purchase shares on the 18th or 19th and hold them until the 22nd to receive the dividend.
Ex-dividend investors in Compass Diversified Holdings can purchase shares for $15.43 and sell the November 2012 $15 call option for a premium of around $0.45. If the shares are not called early, then the trade will result in a profit of 2.3% over 30 days, which is an annualized return of 27.16%. The break-even price on the trade is about $14.66.
Teekay Offshore Partners LP investors could sell the $28 strike price November 2012 call option for a premium of around $0.30. If shares remain above the call strike price at expiration, the trade results in a 2% profit over 30 days held, or an annualized 24.13%. The break-even for the trade is $27.44.
To lessen the risk of shares being called before the ex-dividend date, look at selling an out-of-the-money call with a longer options expiration date. Calculations provided by the Options Industry Council.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.