Last week I wrote Part I of an article on portfolio overwriting, a covered call-like strategy for buy and hold portfolios. In today’s article I will walk you through the process of how this strategy can be accomplished. Keep in mind that there are many ways to approach any given strategy, this is one of them.
Let’s start with our assumptions:
- We have a long-term buy and hold portfolio in a non-sheltered account with many securities having a low cost basis
- Our goal is for the portfolio to generate higher returns and at the same time avoid exercise and subsequent sale of the shares
- If the strike is in-the-money on or near expiration Friday we will roll the option (buy it back and sell the next month’s option)
- On the 4 months where ex-dividend dates come up, we will hold off on selling the option until the ex-date passes or sell a 2-month option
- We will set our goal to enhance our portfolio returns by 6% per year or 1/2% per month
In Part I, I gave a free link to access ex-dividend dates:
Let’s have a look @ Home Depot (HD), a staple in many buy and hold portfolios regarding its ex-dividend date:
I produced this screenshot on November 29th so I will wait through the weekend and sell the option early next week on December 4th. Our other choice would be to sell a 2-month option at the end of the November contracts (the Monday after the third Friday in November). Let’s explore the first choice where we sold a 1-month option the day after the ex-date:
Now with HD trading @ $80.44 and a 6% increase in annualized returns as our goal we will check an options chain for a 1-month return of 1/2% or about $0.40:
The $83, out-of-the-money strike generates $0.41 or .051%, meeting our monthly goal. It also allows share appreciation up to the $83 strike or 3.1% ($2.46/$80.44). If the price of the stock is above $83 by expiration, we can roll the option. Because we waited until December 4th to sell the option, early exercise is highly unlikely.
Next, let’s explore our second choice where we sell a 2-month option also significantly minimizing the risk of early assignment. Below is a screenshot for a 2-month options chain (actually 7-weeks at the time I created this image) for HD:
Please note the following:
- Our 2-month goal is now 1% because our annualized goal is 6%
- With the shares trading @ $80.66, our goal is about $0.80
- Our 2 closest choices are the $82.50 strike ($1.06) and the $85 strike ($0.44)
- If I were dealing with multiple contracts I would do half of each, averaging out to the 1% goal
- If I had only one contract I would favor the $85 strike, take a lower return and allow for greater share appreciation while minimizing the chance of needing to roll the option
- Not every month has a choice of the same strike prices…there is no $83 choice as there was last month
A general risk regarding covered call writing:
Most of our members reading this article already know this but I am including it in this article for those completely new to covered call writing. If a stock dramatically goes up in value, a covered call writer will not partake in any share appreciation above the strike price prior to expiration. This is the reason we are generating modest monthly returns and selling strike prices above current market value thereby having the opportunity to generate 2 income streams each month.
Portfolio overwriting is a low-risk (but not no risk) way of enhancing portfolio value as long as we understand how to circumvent the issue of early exercise in non-sheltered accounts. Since dividend distribution is main reason for early exercise, selling the option after the ex-date or writing a 2-month call option on the month of the ex-date will usually avoid this issue.
Holiday Discount Coupon:
From now through December 24th, the BCI team is offering a 10% holiday discount on all items in the Blue Collar store. Use promo code “HOLIDAYDISCOUNT”
Premium members please enter the store from the premium site to get your additional premium member discount.
Keep in mind my latest book, Stock Investing For Students for friends and family not nearing retirement.
Happy holidays from…
Alan and the BCI team
The bears were roaring most of the week but were quieted on Friday with a favorable jobs report. This week’s economic reports:
- According to the Labor Department, non-farm payrolls rose by 203,000 jobs in November beating the 185,000 consensus
- The unemployment rate decreased from 7.3% to 7.0% in November, below the 7.2% anticipated. This is the lowest level in 5 years
- A second estimate for GDP for the 3rd quarter came in at an annualized rate of 3.6%, well above consensus estimate and due, in large part, to expanding business inventories
- According to the Commerce Department, construction spending in October rose by 0.8%, doubling consensus estimates
- Total construction spending in October was up 5.3% year-to-year
- The Federal Reserve’s beige Book described the economic expansion as “modest t0 moderate” for the time frame from early October through mid-November
- The US trade deficit narrowed by 5.6% in October to $40.6 billion according to the Commerce Department
- New factory orders in October fell by 0.9% after an increase of 1.8% in September
- Personal income declined by 0.1% in October below analyst’ expectations
- Consumer spending rose by 0.3% in October despite the low personal income stat
- The personal savings rate dipped from 5.2% to 4.8%
- The ISM manufacturing index rose to 57.3 in November, the highest level since April, 2011 and better than analyst’ expectations
- The ISM non-manufacturing index (service sector) rose for the 47th consecutive month indicated expansion but came in at the lowest level since June
- New-home sales rose by 25.4% in October to an annualized 444,000 units
- Housing inventories dropped from 6.4 months to 4.9 months in October
For the week, the S&P 500 declined fractionally for a year-to-date return of 29%, including dividends.
IBD: Confirmed uptrend
BCI: This site remains moderately bullish on the economy but will take a cautious approach moving forward as the dip in the unemployment rate may motivate the Fed to taper its bond-buying program. It is unclear how this may impact the market. We are selling and equal number of in-the-money and out-of-the-money strikes.
Have a wonderful holiday season.