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Covered Calls: A Selection Strategy For 10% Income

|Includes:Transocean Ltd. (RIG), VOD

As a retiree, I am a fan of covered calls as a way of achieving high income without courting excessive risk. Over the last couple of weeks, I have written articles on how to select and utilize covered call Closed End Funds (CEFs) in your portfolio. I believe that using CEFs is the easiest way for most investors to profit from these types of investments. However, for the investor who wants more control of his portfolio, there is nothing wrong with buying individual stocks and writing covered calls to enhance your income. This article details my personal strategy for selecting stocks with the goal of achieving a yearly income of at least 10%. I do not contend that this is the "best" strategy and I do not have a long performance history to validate my assumptions but so far, it has worked for me. I welcome comments or ideas from readers that might have suggestions on how to improve my process.

Before I launch into the analysis, I will provide a quick tutorial for the investors that may have missed my previous articles.

The basic idea of investing in covered calls is simple. An investor will buy a stock and write (that is sell) a call option against their stock position. Since the investor owns the stock, the position is termed "covered". This type of strategy is also called "Buy-Write" since you buy a stock and write a call. The call option will give the buyer the right (but not the obligation) to purchase the stock at an agreed upon price (called the strike price) any time before the expiration date of the option. For this right, the call buyer pays a premium to the writer (the investor who sells the option). If the price of the stock increases above the strike price before the expiration date, then the option buyer may "call away" the stock from the writer, that is, the writer is forced to sell the stock at the strike price. If the price of the stock does not increase above the strike price, then the option expires worthless and the writer can pocket the premium. Thus, covered calls are a way to receive additional income but in return, the writer sacrifices some of the upside potential of the stocks.

Of course, the stock could also substantially decline. The premium from the covered call will help offset the losses in the stock but the entire stock-option combination will likely be underwater. If the investor wants to close the position, he will need to sell the stock and the option (selling only the stock would result in a naked call position, which has theoretically unlimited loss potential). Note also that naked calls are not allowed in IRA accounts and require a high level brokerage approval in taxable accounts.

Thus one of the most important decisions in implementing a covered call strategy is stock selection. Some pundits recommend purchasing high beta stocks because you receive high option premiums. However, I think this is one of the largest mistakes an income investor can make since the option caps your upside potential while leaving you vulnerable to the downside. I like stocks that pay relatively large dividends. It is true that the option premium is likely to be small but if you received 6% in dividends you only need to receive an additional 4% from the option to make 10% income per year.

I also try to choose stocks that I believe are "undervalued". This is more of an art than a science and even if you are correct, it does not mean that the price will not decrease substantially. There are many ways of determining value. Morningstar and Value Line offer metrics to aid their subscribers and there are many free articles on Seeking Alpha that discuss value stocks. A good starting point for me is using the FINVIZ website and screening using the following criteria.

Options. Obviously, the stock must have options to implement a Buy-Write strategy.

Market Cap. I choose companies with market caps greater than $2 billion since these should be more stable and established than smaller companies.

Dividend Yield. I require at least 3% but would like more if possible.

Average Volume. The volume must average more than 200,000 shares per day in order to provide liquidity. Also, stocks that have more volume usually also have more options written against them (number of options open is called "open interest")

Price to Earnings (P/E) ratios less than 15. This metric is often used as an indicator of value.

Price to Book (P/B) ratios less than 2. Like low P/E ratios, low P/B ratios are often equated with value.

Price. I require the stock price to be $20 or more. This is a somewhat arbitrary rule but low priced stocks will have even lower priced options.

Applying these criteria at the FINVIZ site on 27 June, I received a list of 20 candidates. The next step is to review the options associated with these candidates to see if you can sell an option that will provide you with a total income of 10% or more. This is not always possible and you may have to wait for opportunities to develop. To aid in this option evaluation, I will provide a quick tutorial on how options are priced.

The theoretical price for an option was first determined by Fischer Black and Myron Sholes in a 1973. Robert Merton expanded the model and in 1997, Merton and Sholes won the Nobel Prize in economics for their contributions to option pricing (Black had died in 1995 and was not eligible for the award). The model is called the Black-Scholes formula and is relatively complicated but the general ideas are easy to grasp. Without trying to be mathematically rigorous, the Black Sholes formula indicates that the price of an option is a function of the following parameters.

Stock price relative to the exercise price. If the stock price is less than the exercise price, the option is said to be "out-of-the-money". My strategy is to always write out-of-the-money options since this provides you with an opportunity to receive capital gains if the stock moves higher. Other conditions are that the stock price equals the exercise price (option is "at-the-money") or the stock price is greater than the exercise price (option is "in-the-money"). Since the price of a stock varies from day to day, it is possible for an option to be in-the-money one day and out-of-the-money the next day.

Time to Expiration. The longer the time to expiration, the more valuable the option. I try to write options with about 3 to 6 months before expiration. You should note that the price does not change linearly with time to expiration. As the expiration date nears, the price of the option will drop rapidly.

Interest rate. This only becomes important when you are writing long term options and the interest rate is high. At today's miniscule rate, you can safely ignore this factor.

Volatility. Volatility is a measure of how much stock returns fluctuate over time. Volatility cannot be directly observed or measured and it so has to be estimated. There are two way to estimate volatility: historical volatility and implied volatility. The historical volatility is based on past data of fluctuations while implied volatility can be inferred from the actual price investors are willing to pay for the option. All the covered call investor needs to know is that the higher the volatility, the greater the probability that the stock will make "large" moves and end up "in the money". Therefore, the higher the volatility, the more expensive the option.

Before looking at actually implementing a covered call strategy, the ideas of "assignment" and "risk management" should also be understood.

The buyer of the option may decide to exercise it at any time before the expiration date. If this happens, the option is said to be "assigned" and the stock held by the option writer is sold at the exercise price and the option position is closed. This will not happen when the option is out-of-the-money since it would be unprofitable for the option buyer to exercise his right. However, consider the following scenario for a high dividend stock when the option is deep in-the-money and the ex-dividend date is approaching. The option buyer can exercise the option, receive the stock by paying the exercise price, and then receive the dividend. Thus, it is likely that the option will be exercised if it is deep in the money and the ex-dividend date draws near. This potentiality should be taken into account when evaluating your Buy-Write position.

The last topic is risk management. If the stock goes down rather than up, the covered call position will become unprofitable. There is no magic way to determine if the stock will continue to fall. Some people use technical analysis while other base decisions on the stock fundamentals. The lesson I have learned is to set a price level where I will reassess my original assumptions and decide if the covered call position still makes sense. There are ways to adjust your positions by buying or selling different options but I have found that most of the time, if my original assumptions are violated, it is better to close the position, take your loss, and move on to another (and hopefully) a more profitable covered call position.

To show how my covered call strategy works, I selected two stocks that passed the FINVIZ screen and performed the analysis described below.

Transocean (NYSE:RIG). Transocean is headquartered in Switzerland and is the international provider of offshore rigs for drilling oil and gas wells. Transocean specializes in deep water drilling to depths of around two miles and is the dominant player in this market. The cost of such a deep water rigs can exceed $600 million and operating costs can top $1 million per day. The major drilling locations are the basins in West Africa, Brazil, and the Gulf of Mexico. Transocean has twice as many deep water rigs as its nearest competitor. Transocean is in the process of spinning off a master limited partnership (NYSE:MLP) called Caledonia Offshore Drilling. This MLP would focus on the North Sea market and would utilize eight of Transocean's older rigs. This is a continuation of Transocean's strategy of divesting itself of non-core assets. After peaking late last year at more than $55 per share, the price fell precipitously to $39 but has now begun to recover. The company had an excellent first quarter, significantly increasing both revenue and net income. With a P/E a little over 10 and P/B less than 1, I consider RIG to be a good candidate for a Buy-Write position. As long as the prices of oil and gas stay high, Transocean should be a good buy at the current price. The data associated with RIG is presented in Figure 1.

Figure 1. Stock and option data for RIG

The next step was to select the option that will provide the overall position with income of at least 10%. Note that I used the price plus the dividend to select the exercise price of $48 and that I selected the November call. Thus, if the option is exercised prior to the ex-dividend date (at the end of August), I will still receive a gain of over 10% for holding the position for 2 months (annualized to over 60%). This condition is shown in Figure 2 under the label "If option exercised before Ex-Dividend".

Figure 2. Potential covered call gains for RIG

Now assume that the option is not exercised before the stock ex-dividend date and that the option moves into the money. If the option is in-the-money at the expiration date, the option will automatically be exercised at a price of $48. You thus have a gain of $3.47 from the stock sale plus $1.1 received from the option plus the quarterly dividend of $0.75 for a total profit of $5.32 or 11.9% (29.5% annualized).

The last condition shown in Figure 2 is when the option is not exercised and expires worthless. In this case, you receive the $1.1 option premium plus the $0.75 dividend for a total of $1.85 or 4.2%, which still achieves the goal of a 10% annual return (assuming you can sell another call and repeat the process. Thus Transocean passed by criteria and I plan to buy it for the covered call portion of my portfolio.

Vodafone Group PLC ADR (NASDAQ:VOD). Vodafone is a leading international provider of mobile communications. It operates in more than 30 countries and has over 400 million customers. VOD is well positioned for increasing market share in emerging markets, especially Africa and India. Vodafone has also been active on the merger and acquisition front, selling its stake in Verizon Wireless and purchasing Kabel Deutschland, the largest cable provider in Germany. In addition, Vodafone has announced a joint partnership with Rogers Communications, which is one of Canada's largest wireless voice and data providers.

The price of VOD increased early this year due to speculation that AT&T might make a takeover bid. However, AT&T decided to acquire DirecTV for $49 billion, which decreased the potential for a takeover of Vodafone, This coupled with worse than expected earnings last year has but pressure on the stock price, causing a decline of over 20% since February. The drop in price has increased the dividend yield to a very attractive 7.4% (paid semiannually). Vodafone has an excellent balance sheet with over $9 cash per share and a debt to equity of only 0.41. A summary of data is shown in Figure 3.

Figure 3. Stock and option data for VOD

I believe the recent weakness is a buying opportunity and the high dividend coupled with covered call premiums achieves my criteria of a 10% income return. I selected the January, 2015 call with a strike price of $36. The potential gains from this covered call position are shown in Figure 4.

Figure 4. Potential covered call gains for VOD

In summary, here are some tips for investors interesting in writing covered calls.

1) Write covered calls on dividend paying stocks.

2) Choose an exercise price that will allow you to capture at least the size of the dividend if the option is assigned

3) Select options expiring in 3 to 6 months.

4) Decide in advance what you will do if the stock price does down

5) Select positions that will provide a 10% annualized return even if the option is exercised

Bottom Line

I believe a covered call strategy is a good way to increase income if you can handle the risks of stock ownership. I have presented some techniques for selecting stocks and options but there is no guarantee of profit. Anything can happen in the market (and usually does) so all readers should perform their own due diligence before investing. That said, if you are interesting in income, you should give covered calls careful consideration.

Disclosure: The author has no positions in any stocks mentioned, but may initiate a long position in RIG, VOD over the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

Stocks: RIG, VOD