By Robert Hauver
With the recent choppy market action, you may be wondering how best to protect your gains, without abandoning your income-producing dividend paying stocks. Selling Covered Calls offers you another income stream from your stocks, in the form of option premiums. This week we’ll walk through covered call trades for three dividend stocks from our High Dividend Stocks By Sector Tables. Two of these stocks, ABT and PG, are Dividend Aristocrats:
Covered Calls (Expiring Jan. 21, 2012):
(We’ll use a one contract sale in our examples, for simplicity’s sake. Each call options contract corresponds to 100 shares of the underlying stock.)
ABT covered call trade:
1. Buy 100 shares of ABT at $52.40.
2. ABT closed at $52.40, and you’d “sell to open” a Jan. 2012 $52.50 call option, “at the money”, i.e., close to the stock’s current price.
You receive a premium of $2.17/share, ($217.00 per option contract), more than twice ABT’s dividend during this 6-month period.
3.During the next 6 months, you’d also collect 2 quarterly dividends, for a total of $96.00.
So you’ve collected $96.00 in dividends, plus $217.00 in call option premiums, thereby turning a 3.69% dividend yield into a 12.05% static yield, 0ver 3x the dividend yield.
(Static yield refers to a scenario in which your stock doesn’t rise enough to be assigned/sold away from you at expiration time. In general, if the underlying doesn’t rise to or past the approx. combination of the strike price and the call premium, your shares won’t be called away. However, other factors, such as an upcoming ex-dividend date, can sometimes make it worthwhile for a call buyer to exercise the option to buy the shares.)
4. Two Possible Expiration Scenarios:
Static Yield – You keep your shares, for a static yield of 12.05%.
Assigned Yield – Your shares are assigned/sold at the $52.50 strike price, and you receive an additional $10.00, (the $.10 difference between the $52.40/share cost and the $52.50 strike price times 100 shares). Your total annualized gain is 12.43%
Note: We used the $52.40 price to illustrate the yields in this trade. If you already owned ABT, just use your cost basis to calculate your yields and gains.
Advantages of selling Covered Calls:
1. Quicker Income/Better Cash Flow: You receive the option $ within 3 days of selling, often the same day, as opposed to waiting for quarterly dividends.
2. Lower Your Risk: The call option $ you receive also lowers your break-even cost, thereby giving you a stronger defense vs. market downturns.
3. Tax Deferral: If the call expires, or isn’t exercised until 2012, you don’t have to pay taxes on it until April 2013.
1. When you sell a call, you’re obligated to potentially have to sell your underlying shares at a specific strike price by the expiration date. Your upside price gain potential is limited to the combo of the strike price plus the option $ you received. In the ABT example, it’s $54.77: the strike of $52.50, plus the $2.17 option premium, plus the potential $.10 if the shares are assigned/sold.
The judgment you need to make is whether or not you think your shares will rise considerably past this point, or if you’d prefer to get paid now, and gain more risk protection if the market falls.
GE covered call trade:
(You can find more details on these 3 trades and other Covered Calls trades in our Covered Calls Table.)
This GE trade has the highest static and potential assigned yields of these 3 trades, due to its call bid premium of $1.14 yielding 12,23%. GE decreased its dividend from $.31/quarter to only $.10 during 2009, but has brought it back to $.15/quarter in 2011.
Another advantage of selling covered calls is that, unlike dividends, the company can’t control your payout. Once you’ve sold a call, that $ is yours to keep, unlike future dividends, which may be cut at any time by the company, which happened quite often in the downturn. Fortunately, firms are back on the track to restoring and increasing their dividends, so that negative trend has been reversed, for the time being.
This trade also expires in Jan. 2012, roughly 6 months.
1. Buy 100 shares of GE at $18.79.
2. Sell the Jan. 2012 $19.00 call for $1.14/share, and receive $114.00 within 3 days.
3. Collect $30.00 in dividends prior to expiration.
4. Expiration outcomes: The same two possible scenarios –
Assigned: GE rises approx. to or above $20.14, (the combo of the $19 strike price plus the $1.14 call bid), your shares get sold for $19.00, and you’ll receive an additional $21.00, (100 shares time $.21/share; the difference between $18.79 cost and the $19.00 strike). You’ve made 17.71% annualized, 5.5 times the original 3.22% dividend yield.
Static: GE doesn’t rise to approx. to or above $20.14, and your shares aren’t assigned/sold away. You’ve made 15.45% annualized, nearly 5 times the original dividend yield.
(The details for the PG trade are listed in our Covered Calls Table.)
Disclosure: Author is long GE shares, long PG shares, and short PG calls.
Disclaimer: This article is intended for informational purposes only.