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Covered Call Writing And Dividend Capture: Evaluating A Proposed Strategy

Capturing dividends using covered call writing has been a topic on great interest lately. I recently wrote an extensive white paper on this topic located in the “resources/downloads” section of your premium site. In this article I will evaluate an interesting approach to a strategy recently sent to me by one of our members who read it online.

The basis of this game plan is to buy the stock prior to the ex-dividend date (date we must own the shares to be eligible to collect the dividend) and then sell a deep in-the-money call option that is trading with a delta of  “1” On the ex-date, we now qualify for the dividend and two price changes are expected: both the value of the stock and that of the option drop by the amount of the dividend. These changes are based on the fact that share price does decrease by the amount of the dividend, no argument there. If the option is trading with a delta of “1” then it, too, should decline by a similar amount. If we then buy back the option at a lower price and sell our shares at a loss, the two positions will cancel each other and now we simply wait to collect the dividend. Finally that free lunch we have been searching for, right? That, ladies and gentlemen, was a rhetorical question.

Here is the example sent to me to demonstrate how this proposed methodology plays out:

  • Prior to the ex-date, buy 100 x BCI @ $50.00
  • Sell 1 x $40.00 call @ $10.20
  • Dividend to be distributed is $1.50 per share
  • On the ex-date, share value decreases to $48.50 and option value declines to $8.70 (subtracting $1.50 from both)
  • We lose $150.00 in share value and gain $150.00 on the option side for a wash
  • Collect $150 on the distribution date

Let’s examine this trade in detail to see if lunch is really free.

 

What about that $1.50 dividend?

A quarterly dividend of $1.50 annualizes out to $6 or 12% for a $50 security. How many quality stocks generate such a dividend and do we want to get involved with stocks that do? Covered call writing and even dividend capture is a low-risk strategy for conservative investors who emphasize capital preservation.

 

What about that $40 call option having a time-value component of $0.20?

This would be quite unusual for a quality stock trading so far deep in-the-money such that the option would have a delta of “1” Instead we would anticipate that option trading at parity or intrinsic value only ($10, in this situation), sometime even with a negative time value. Let’s have a look at Facebook trading @ $74.57 with a $64.50 strike, a similar situation to this hypothetical:

covered call writing and dividend capture

Facebook: deep in-the-money option with a delta of “1”

 

In the yellow-highlighted cells on the left side of the chart we see the difference between the deep in-the-money strike and the stock price is $10.07, similar to the hypothetical trade. In the yellow-highlighted cell on the right side of the chart we see that the option premium is trading at parity which is expected for such a deep in-the-money strike. In the pink cell on the right side, note that the delta is “1′ as proposed in the hypothetical. When there is a time value component to the option premium for a strike $10 in the money for a $70 stock, then the market is anticipating a potential huge price movement by expiration and that is not what covered call writers are looking for…too much risk.

 

What about commissions?

The proposed trade has four legs and therefore four commissions: buy stock, sell option, buy option, sell stock. Let’s estimate a total debit of $40 for these trades. Now the proposed dividend yield was 12%. Let’s look at a more common 4% yield.  For a $50 stock that is $2 annually or $0.50 quarterly which equals $50 per contract. Now deduct the $40 in commissions. Free lunch? We may have to settle for Burger King with a coupon.

 

Who will actually collect that dividend?

In the proposed trade, the time value component of the option is $20 per contract. If the option is sold, this would be the credit or profit. The proposed dividend is $150. Now here’s another rhetorical question: If you were the option holder, would you exercise the option prior to the ex-date to generate a dividend credit of $150 or sell the option for a credit of $20? Me too. Most option buyers who are taking the other side of our trades also know a little something about dividends and the chance of early exercise is real and probable when the time value of the option is less than the dividend about to be distributed. It is also more likely the closer the ex-date is to the expiration date.

 

Conclusion

We have to pay for lunch and the best way of affording the meal is to sell traditional covered calls. Now, admittedly, I have written this article a bit tongue-in-cheek but should add that I always respect those who are looking for ways to increase profits with different approaches to our methodology. However, I always advise to look closely at any strategy that appears to be too good to be true because it usually is.

 

Next live seminars:

Denver, Colorado

Monday May 18th…click for details.

7 Pm – 9 PM

I will be focusing on covered call writing but will also provide a segment on selling cash-secured puts.

 Same day: Boulder, Colorado

Group- AAII Sub Group- contact

Clint Heiple

720/562-8067

ClintH.1@comcast.net

Frasier Meadows Retirement Community

350 Ponca Pl, Boulder, CO 80303
(303) 499-4888
 

1:30 PM – 3 PM

Market tone

US and European stocks rallied on the monthly US employment report after global markets had declined on uncertainty over the UK general election and Greece’s future in the eurozone. US Federal Reserve Chair Janet Yellen’s comments about high valuations also negatively impacted stocks earlier in the week. This week’s reports leaned to the positive:

  • The US labor market posted a nonfarm payrolls gain of 223,000 in April
  • The unemployment rate fell to 5.4%, the lowest since May 2008
  • Hourly wages grew 3 cents to $24.87, up 2.2% from a year earlier
  • Initial claims for US unemployment benefits rose 3,000 to 265,000 for the week ended  May 2, near a 15-year low. The four-week moving average fell 4,250 to 279,500
  • Continuing claims decreased 28,000 to 2.23 million for the week ended 25 April, the lowest reading since November 2000
  • The US trade deficit increased to $51.4 billion in March, the largest gap since October 2008
  • New orders for US manufactured goods rose 2.1% in March, the biggest increase in eight months
  • The Institute for Supply Management nonmanufacturing purchasing managers’ index rose to 57.8 in April from 56.6 in March
  • The service sector PMI slipped to 57.8 from a f March reading of 59.2.
  • First-quarter US nonfarm productivity fell by 1.9% annually, following a 2.1% decline in the fourth quarter, making this the first back-to-back quarterly decline since 2006.

For the week, the S&P 500 rose a fraction of 1%  for a year to date return of 2.8%.

Summary

IBD: Market in correction

GMI: 1/6- Sell  signal since market close of May 7, 2015 (before Friday’s rally)

BCI: Cautiously bullish and using an equal number of in-the-money and out-of-the money strikes. The triple digit moves in the market are still unsettling although the late week rebound was admittedly impressive. I remain bullish but defensive.

Wishing you the best in investing,

Alan (alan@thebluecollarinvestor.com)

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About Alan Ellman

Alan Ellman loves options trading so much he has written four top selling books on the topic of selling covered calls, one about put-selling and a sixth book about long-term investing. Alan is a national speaker for The Money Show, The Stock Traders Expo and the American Association of Individual Investors. He also writes financial columns for both US and International publications along with his own award-winning blog.. He is a retired dentist, a personal fitness trainer, successful real estate investor, but he is known mostly for his practical and successful stock option strategies.

13 Responses to “Covered Call Writing And Dividend Capture: Evaluating A Proposed Strategy”

  1. Barry B May 9, 2015 3:38 pm #

    Premium Members,

    This week’s Weekly Stock Screen And Watch List has been uploaded to The Blue Collar Investor premium member site and is available for download in the “Reports” section. Look for the report dated 05/08/15.

    Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them at The Blue Collar YouTube Channel. For your convenience, the link to the BCI YouTube Channel is:

    http://www.youtube.com/user/BlueCollarInvestor

    Since we are in Earnings Season, be sure to read Alan’s article,
    “Constructing Your Covered Call Portfolio During Earnings Season”. You can access it at:

    http://www.thebluecollarinvestor.com/constructing-your-covered-call-portfolio-during-earnings-season/

    Best,

    Barry and The BCI Team

  2. Yadao May 10, 2015 7:46 am #

    Hi: Dr. Ellman: I finish reading your “Selling Cash-Secured Puts” book, which is an excellent book.

    Also, I thank you for lessons on Covered Calls. It really helps me to understand thoroughly. However, sometimes I have a problem of understanding of situations such as:

    If you have sold a OTM CC and if it goes ITM, I am thinking to roll this CC for next month to cover the loss, Is that seems to be correct or take a loss and close the call?

    Also, can you please, explain me with an example “when they say the trade expired worthless? and if it’s not expired worthless then what type of circumstances take place?

    What action supposed to be taken to protect profit or the base capital?

    I appreciate your help & thank you.
    Yadao

  3. Alan Ellman May 10, 2015 8:41 am #

    Yadao,

    Thank you for your generous remarks. My responses:

    1- If a strike ends up in-the-money there is no loss. You have maxed your trade (option premium + share appreciation up to the strike)…nice trade!

    2- Rolling the option may be appropriate if the stock is still eligible (no earnings report) and if the returns meet your goals (option credit minus option debit divided by strike of original option).

    3- When an option expires worthless it expires out-of-the-money. An example is if you sell a $50 call option and the stock at expiration is under $50…that option will expire worthless. We will retain our option premium + our shares as the next contract period begins.

    4-There are a number of position management strategies that should be implemented if a trade turns against us or even if it turns out to be better than anticipated. All my books and DVDs are dedicated to position management techniques. A brief response in this venue would not be adequate.

    Alan

  4. Greg May 10, 2015 8:47 am #

    Hi Alan,

    Looking at the stocks from the BCI weekly watch list, the markets are usually very wide and I’m wondering how you feel about that. These very wide bid-asks spreads are making it difficult for me to feel comfortable and I’m curious about your feelings regarding it.

    Greg

    • Alan Ellman May 10, 2015 8:55 am #

      Greg,

      Frequently the spreads appear larger over the weekend and will decrease when markets open on Monday. Also, be sure to take advantage of leveraging the “Show or Fill Rule” when setting limit orders for option sales (pages 225 – 227 of the “Complete Encyclopedia…”). This week’s report has a healthy list of eligible candidates and we should have no issues finding stocks with bid-ask spreads we can work with. Re-check Monday morning after 11 AM.

      Alan

  5. Lloyd May 10, 2015 12:17 pm #

    Alan,

    I’ve been selling covered calls on CTSH since last November getting about 2% each month but sold the stock last month when the price dropped below the 20 day moving average. I see it’s now back on our stock list and I’m thinking of jumping back in. Is it better to enter a position this week or wait for the May contracts to expire for June positions?

    I appreciate your thoughts on this.

    Lloyd

    • Alan Ellman May 11, 2015 10:56 am #

      Lloyd,

      I generally wait for the beginning of the new contract because of the logarithmic nature of theta (time value decreases slowly at the beginning so less time-value premium is lost earlier than later). We are incurring less risk without costing us much premium.

      Alan

  6. Joe May 10, 2015 12:37 pm #

    Alan,

    How can avgo be on this weeks list when it is reporting earnings on May 28?

    Joe

    • Alan Ellman May 10, 2015 12:42 pm #

      Joe,

      In our reports, we break down eligibility by contract month, NOT calendar month. Please note the broken black lines on the “running list” The May contracts expire on 5-15-15 so AVGO is eligible for May but will not be eligible for the June contracts until the earnings report passes on the 28th.

      Alan

  7. Adrian May 11, 2015 4:37 am #

    Alan, I have a mix of questions below with them being put under their headings this time, just about some various things I think are of importance:-
    Returns.
    1. If I am in the middle of the contract and am choosing between a few stocks to use, then should I also check to see that the return for an ATM strike is no greater than 3% for stocks, and 1.50% for ETF’s?(half the normal amounts)?
    MCU.
    2. If you sell ITM options for the 2nd stock of a MCU strategy, then wouldn’t it be best to do the same for the 2nd call written for the ‘Hit a Double’ strategy, as this could be near the middle of the contract month too?(if you don’t think so then can you tell me why?)
    Gapdowns.
    3. After a stock gaps down then how many days will you wait for the price to consolidate s/ways?
    4. And when it does actually move in a s/ways range, then how long do you again wait in the hope for price to go back up? (I do suppose this could be anywhere from a day to over a week or more)?
    RS line.
    5. Lastly if as I wish to incorporate the ‘RS line’ with my other indicators then would you say that it should always be trending up to show market outperformance, if I am thinking of buy a stock – from the look of the other indicators, chart, etc? (if it goes S/ways or inline with the market performance then I am guessing the stocks future performance may not be as great, or could it be alright you think?)

    Thanks for any advise with these subjects here.

    • Alan Ellman May 12, 2015 2:05 pm #

      Adrian, My responses:

      1- This is a good guideline…perhaps a drop lower due to the logarithmic nature of theta.

      2- In the first week of a contract, everything is in play. By mid-contract I would opt for an ITM strike unless we are in a strong bull market with strong chart technicals.

      3- 2-3 days as a guideline

      4- Assuming the news that caused the gap-down was not egregious and consolidation took place, I would start selling OTM strikes after the first few days. We can always re-visit that decision at the end of the contract.

      5- I have no issue incorporating additional technical indicators but let’s not hang our hat on it or any other one. We have a series of many screens and no one screen by itself should impact our decisions. RS lines can confirm or contradict other indicators and that may lead to more bullish or bearish covered call positions (ITM or OTM).

      Alan

  8. Mark May 12, 2015 2:06 pm #

    Why not sell 1 or 2 week covered call options since the premiums are still often good as opposed to 30 day? It would seem to be more profitable. Thanks!

    • Alan Ellman May 12, 2015 2:14 pm #

      Mark,

      I have no issue with members who prefer weeklys as long as we understand and trade according to the pros and cons of those products. Those who trade weeklys believe they can achieve higher annualized returns, so let’s call that one possible advantage. Also, we can trade weeklys up until the week before an earnings report and then the week after thereby having the ability to use a security more frequently than we can for monthlys.

      On the other side of the column, we are selecting stocks and ETFs from a smaller pool, have less time for exit strategy maneuvers, have more frequent “rolling” decisions and have double or quadruple the number and amount of trading commissions.

      I personally prefer monthlys but believe that excellent returns can be generated from weeklys as well as long as we master all three required skills (stock selection, option selection and position management).

      Alan

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