Enhancing Yield On Diageo With Covered Calls Using LEAPS

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Includes: DEO
by: Larry Wishnick

Summary

Covered calls are a great way to enhance return on stocks you own for the long term.

This strategy should be implemented on stocks you think will appreciate a small amount over the term of the option contract.

Diageo is a good candidate for this strategy, if you own the stock.

Diageo PLC (NYSE:DEO) is well run company, that offers investors international diversification and a large dividend. It is a core long term holding in many portfolios.

A good way to enhance return on this type of position, is to write calls against the shares you own. This is commonly known as a covered call strategy. If you own the stock for the long term, a covered call strategy, using LEAPs (long term equity anticipation securities), is something to consider. LEAPs are options with an expiration date that is farther out in time. Usually, one to three years. By selling longer term options, you will receive a higher premium. The downside is that you will tie up your position for a longer time.

The Trade

I am looking to sell the 120 calls on Diageo that expire on January 19, 2018. Each option contract represents 100 shares of stock. So, one contract will need to be sold for every 100 shares owned. You can see what the market looks like here.

DEO Option Quote

Source: optionstrategies.info

If the options can be sold at the bid price, the sale price would be 2.9. This would net the seller $290 per 100 shares owned, since one contract represents 100 shares. One contract should be sold for every 100 shares owned.

Two Potential Outcomes

Two potential outcomes are that Diageo stays below or at 120 at expiration, or the prices rises above 120.

Scenario one: the stock price stays under 120 at expiration. In this case, the yield from income received will go to 5.90%. This is up from the 3.27% dividend yield (3.69 dividend per share) that is currently paid. There is also the potential for price appreciation. Diageo is trading at 111.67. It could rise to 120 without being called away. Therefore, the overall potential gain is 13.36%.

On the flip side, the call seller could still end up with a negative return if Diageo stock price goes down. A drop below 105.08 (111.67-3.69-2.90) will result in a loss.

Scenario two, the stock price rises above 120. In this case the covered call seller, will have effectively sold at 122.9. The 13.36% return will be realized. However, the seller will lose out on any additional capital appreciation, above 120, since the shares will be called away above that price.

Basically, the covered call strategy works best when the underlying stock rises a small amount over the term of the option contract. I think it makes sense to sell calls against a long position in Diageo, since I believe that this will be the case for the stock, over this year.

Some Consideration

Here are some things to consider before implementing this strategy

1) Transaction costs. This should be no more than $5 per contract.

2) Tax Consequences. The premium received gets taxed as a capital gain. You may also be on the hook for a capital gain on the selling of the stock, if it is for a profit.

3) You are tying up your assets until the option contract expires. Unless, you look at unwinding the transaction, which could end up being a problem, with an illiquid contract.

4) Keep in mind that most brokers will require an account to be approved before a covered call can be sold. There are usually different levels of approval for option trades. Getting approval to implement a covered call should not be a problem if you have the capital to cover the trade in your account.

Summary

A covered call strategy is a good way to enhance returns on stocks that you own. Selling options that have a longer term to expiration will provide you more income, with the cost of having to tie up your position for a longer time frame. Look to implement this strategy on stocks you own, that you think will not appreciate too much over the term of the option contract. Diageo is a potential candidate for this strategy.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in DEO over 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.

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