Generating a consistent cash flow from stock dividends is an appealing benefit from owning shares for many investors. Stock ownership, in these scenarios, can create two income streams, one from price appreciation and the other from quarterly dividends. However, not all securities have associated dividends and some investors will bypass these stocks even if they are quality securities which represent potential impressive returns. Enter covered call writing. By selling call options against shares we hold in our portfolios, we can take a non-dividend bearing stock and create our own “dividends”
Dividends and our Blue Chip Report of Top-Performing Dow 30 Stocks
Blue Chip Report July-2018
The brown-highlighted column reflects the annualized dividend yield of the top-performing Dow 30 stocks prior to the July 2018 option contracts. The 10 securities listed in the report averaged an annualized dividend yield of 1.73%. The stock closest to this average is Microsoft Corporation (NASDAQ: MSFT) which had a dividend yield of 1.65%. Let’s see how much a call option would yield in the 24-day period from July 24th through contract expiration on August 17th:
Microsoft option chain for August 2018 expirations
MSFT Option Chain for August 2018 Contracts
Let’s say MSFT did not yield this 1.65% annualized dividend and we wanted covered calls to create this yield using a practical, efficient methodology. Let’s round off our goal to 2% annually. If we were to write 4 quarterly covered calls, our goals would be to generate 0.50% per quarter. With MSFT trading at $107.46, we know 1% would be about $1.07 so 1/2 of 1% would be about $0.54. The bid column (B) of the option chain shows a price of $0.54 for the out-of-the-money $111.00 call. We follow this procedure 4 times a year and lo-and-behold, we have created a second dividend. In addition to this 0.50% profit, MSFT has the opportunity to rise in price from $107.46 up to the $111.00 strike, another 3.3% of potential share appreciation.
Earnings report risk
The main concern relating to this strategy is when a stock moves well above the strike sold and not allowing us to take full advantage of this share appreciation. The most likely time this may occur is when there is a favorable earnings release. To circumvent this risk, we will never select a contract period that encompasses and earnings report. We should also master our position management skills whenever option-selling is used.
Ex-Dividend date risk and early exercise
The most likely time for early exercise is the day prior to the ex-dividend date. We should avoid these dates as well.
Stocks without dividends: Micron Technology, Inc. (NASDAQ: MU)
MU was an eligible stock on our premium stock report for the August 2018 contracts and did not have an upcoming earnings report prior to contract expiration. The stock was trading at $53.72 on July 24th and so we will target a 24-day return of $0.27 to align with our 2% annualized goal for this “dividend replacement” Let’s have a look at the option chain on July 24th:
MU Option Chain on July 24, 2018
The $55.50 strike would be most appropriate as the premium generated would result in a 0.58%, annualizing to 2.3%.
Discussion
Covered call writing can be crafted to meet various trading styles and meet a wide range of personal risk tolerances. For investors who value dividends, covered call writing is a wonderful approach to either creating dividends that don’t exist or enhance stock returns that already generate dividends.
New Blue Chip Report
Premium members:
The latest Blue Chip Report of the best-performing Dow 30 stocks is now available on the premium member site. One stock was eliminated and three were added since last month’s edition.
Upcoming event
February 7th – 10th, 2019
Orlando Money Show
Omni Orlando Resort @ Champions Gate
February 7th – 10th 2019
Speaking schedule:
1. Getting Started with Stock Options: Creating Monthly Cash Flow with Covered Call Writing
February 8, 2019, 3:10 pm – 3:40 pm
2. Getting Started with Stock Options: How to Select the Best Options in Bull and Bear markets
February 9, 2019, 2:00 pm – 2:45 pm
New seminar just added
Charlotte North Carolina:
September 14, 2019
9:30 AM – 12 PM
Your generous testimonials (new feature)
Over the years, the BCI community has been incredibly gracious by sending our BCI team email testimonials sharing stories as to what our educational content has meant to their families. Moving forward, we have decided to share some of these testimonials in our blog articles. We will never use a last name unless given permission:
Alan,
Reading your book Encyclopedia for Covered Call Writing. I have been selling call options for several years with acceptable results. Your book has given me new perspective and will most likely double my yield. Thank you very much.
Gordon T.
Market tone
This week’s economic news of importance:
- Producer price index Dec. -0.2% (-0.1% expected)
- Home builders’ index Jan. 58 (56 last)
- Weekly jobless claims 1/12 213,000 (220,000 expected)
- Philly Fed index Jan. 17.0 (9.1 last)
- Industrial production Dec. 0.3% (as expected)
- Consumer sentiment index Jan. 90.7 (97.5 expected)
THE WEEK AHEAD
Mon Jan. 21st
- None scheduled
Tue Jan. 22nd
- Existing home sales Dec.
Wed Jan.23rd
- None scheduled
Thu Jan. 24th
- Weekly jobless claims 1/19
- Markit manufacturing PMI Jan.
- Markit services PMI Jan.
- Leading economic indicators
Fri Jan. 25h
- Durable goods orders Dec.
- New home sales Dec.
For the week, the S&P 500 moved up 2.54% for a year-to-date return of 6.54%
Summary
IBD: Market in confirmed uptrend
GMI: 2/6- Bearish signal since market close of November 13th, 2018 as of 1/17
BCI: With volatility (VIX) under 20, I am taking a more aggressive stance and favoring out-of-the-money strikes 3-to-2 compared to in-the-money strikes.
WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US
The 6-month charts point to an improving market tone. In the past six months, the S&P 500 down 5% while the VIX (17.80) moved up by 38%. We can’t forget that the VIX was more than double the current rating on December 24th (36.07).
Wishing you the best in investing,
Alan and the BCI team
Alan,
I bought ALRM on 1/16 for 56.28 and sold the feb 15 60 call for 1.85. I panicked when the stock price went higher then 60 and sold my shares. Did I do the right thing?
Ralph
Ralph,
All is well. You made some good money in a short time frame.
Let’s look at the trade as you set it up originally using the multiple tab of the Ellman Calculator (see the screenshot below):
Your initial return is 3.3% and the upside (which is currently met because the stock price is above the $60 strike) is another 6.6%. Your total potential profit was 9.9%. Since you closed the position, you must deduct the cost-to-close which may have cut your profit in half depending on the option price when you closed the position…still a nice profit.
Now, what the best action at this point in time should be: Take no action and continue to monitor the trade. The cost-to-close was probably too high to justify closing. See the exit strategy chapters in the Complete Encyclopedias…Still made some nice money.
CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG.
Keep up the good work,
Alan
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 01/18/19.
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:
https://www.thebluecollarinvestor.com/constructing-your-covered-call-portfolio-during-earnings-season/
The latest Blue Chip Report of the best-performing Dow 30 stocks is now available on the premium member site. One stock was eliminated and three were added since last month’s edition.
Best,
Barry and The Blue Collar Investor Team
barry@thebluecollarinvestor.com
I have one main concern about covered call I got in Sirius @$3.89 I have 2,000 shares Siri now sits at 6.07 which covered call strategy should I use to get the 50% gain that a stocks appreciate in value also what are the best covered call to use on bonds, currency ETFs. Do you use any indicators like MACd or RSI to get in or out of trade via covered call.
Thanks,
Pat
Pat,
When we are bullish on a security, the best covered call to use is an out-of-the-money strike. This allows us to benefit from both option premium and share appreciation up to the strike price.
Our underlyings are stocks and ETFs.
Although there are many technical indicators that can be used, the ones that have worked best for me over the past 25 years for covered call writing are:
Exponential moving averages (20-d and 100-d)
MACD histogram (12,26)
Stochastic oscillator (14-d)
Volume
The indicators should include trend and momentum indicators with volume confirmation specific for short-term trading.
Alan
Pat,
Another consideration when you own 2000 shares of a probable growth stock like SIRI is simply cover less of it. You could write 20 contracts a month or you could write maybe 10, pick a number, and let the rest run.You can also ladder your strikes selling some ITM to guard against down moves and some as far out of the money as there is premium enough to make it worthwhile.You have all sorts of flexibility when you have that many shares! I try to have at least have 200 shares of any stock or ETF so I can cover half and let the other half run in normal markets, for whatever that is worth :)?
Alan,
Thanks for another great blog article, as always! To your point I suspect few people think of gold as an income investment? I do. I have held a GLD position for years as portfolio diversification and overwrite it consistently for monthly cash flow. Certainly no earnings report or dividend risk on that one :). – Jay
Great tips, Jay. Reminders on ways to diversity an investment. On a volatile market we have to day will be a winning strategy some of the time.
Mario
Jay,
Great points. GLD has frequently earned its way onto our premium member ETF Reports. In our most recent report, GLD has been up in price 4% over the past 3 months compared to the 1% decline in the S&P 500. The implied volatility of GLD was at 9.23 (as of Wednesday evening) while that of the overall market was 16.96.
Alan
Good Day team!
I must thank you for sending out the Sunday morning edition of the BCI email each week. I look forward to this new edition and view it as a serious item in my continuing education in option writing!
Jim
Much appreciated from the BCI team.
Hello Alan
I am new to the covered call and option trading concept. I have been trying to learn as much as I can, but I do have a question on stocks that skyrocket in price. At the beginning to mid December I wanted to jump in and try doing some paper calls. This was before I learned what to look for in a stock. I am Canadian so I picked Lululemon (LULU) and I am in the technology industry so I picked Salesforce (CRM).
I bought LULU for $127 and did my covered call, @ strike of $127 the price dropped to $113, but that was ok, cause I was learning, (earnings report came out) so the next call I did at strike of $125 and lo and behold the stock zoomed up to $152 – needless to say I did make money, but not as much money as I would have if I just held the stock. The same thing basically happened with the CRM stock – bought it at $137 and again the stock zoomed to $152. So my first question, I know it was just dumb luck picking the stock, but is this normal for stocks to jump this much in a little over a month. Second question, if you go through the fundamental and the technical aspects of the stocks, find they are trending up, pass all of the tests, then wouldn’t these be stocks be ones that you would buy and hold, as opposed to selling covered calls. Right now with what I just saw on my LULU and CRM stocks – going back they would have passed the fundamental and technical tests.
Wouldn’t it make more sense to find a stock that is in a sideways pattern?
Any help would be appreciated.
Thanks
Patti
Patti,
Welcome to the BCI community. You have asked excellent questions.
1. This type of price movement (down 10% then up 35%) is not typical for most stocks that meet the BCI criteria. The volatility can be evaluated by viewing the time value option returns [use the “multiple tab” of the Ellman Calculator and look at the “ROO” (return on option) column]. If ROO is too high for near-the-money, 1-month returns (say >6%) we may want to use a different underlying depending on personal risk-tolerance. Part of the issue with LULU was related to a disappointing earnings report (on 12/6) which must be avoided in the future.
2. Covered call writing lowers our cost-basis and that is why we should beat the market on a regular basis. Also, the specific screening for covered call writing is geared to short-term commitments.
3. Elite-performers from both fundamental and technical perspectives give us the best chance for success. If our initial trade structure gives us a chance for a 6%, 1-month return and share price moves even higher than the strike, who cares, our maximum return has been achieved.
Alan
Ralph,
Complementing Alan’s comments here is my analysis.
Excellent pick and and nice to see the quick rise to the OTM strike at the very beginning of the cycle.
2/15/19 Buy 100 Sh ALRM at 56.28 (underlying)
2/16/19 STO 1Cn 60CA at 1.85 (OTM Call)
Return Cost Basis (RCB) = 56.28
Breakeven 56.28 – 1.85 = 54.43
ROO (remains at 56.28) = 1.85 / 56.28 == 3.29% (Gain or Profit = .0329 x 56.28 x 100 = $185.16, or $1.85 x 100 = 185)
Upside Potential (3.72) = 60 / 56.28 == 6.61%
Total Return if price remains above 60 and exercised or assigned at expiration: 3.29% + 6.61% = 9.9% (Gain = .099 x 56.28 x 100 = $557.17. Check – 1.85 + 3.72 == 557.00 / 100 shares
******
2/18/19 ALRM rises and closes at 60.38, ITM for your strike 60 call.
From Option Table for ALRM Strike 60 Bid Ask is 2.70 / 3.00 or midpoint of 2.85.
If you unwind your position with this BTC premium (Mid Contract Unwind (MCU) exit strategy) (Unwind now Tab if Use Ellman Calculator-Pg 264 Encyclopedia Vol. 1), here are the calculations:
* 2.85 corresponds to an intrinsic value of 0.38 and Time value of 2.47 (underlying 60.38). The cost to close with a time value of 2.47 is 2.47 / 56.28 is 4.39% using the original cost basis as reference. (The Ellman calculator uses the Strike as a reference for a value of cost to close of 2.47 / 60 = 4.12%).
The net return is then 9.9% – 4.39%=5.51%. Gain is then .0551 x 56.28 x 100 = $310.00. Alternatively using the time value changes 1.85 + 3.72 + 2.47 = $310.00 / 100 shares.
To guarantee a max loss of 4.39%, you can place a combination order to Sell the covered call (sell with a buy to close) with a credit limit of (Strike – Time Value) = 60 – 2.47 =57.53. This equation, which I have discussed in an earlier blog post, for the credit limit is only valid for ITM calls, not OTM calls.
As Alan mentioned the Cost to cost loses 4.39% is your net profit (Ellman calculator show 4.12% cost to close using the current strike as reference, but 4.39% is the loss to your net profit) so your profit would be improved by waiting for the time value to decay to a more optimum value as described in Exit Strategies for a Mid Contract Unwind. Alan generally recommends you close if you can find another investment and realize a return ROO of 1% plus the cost to close.
For a stock that has gapped up, I generally set a threshold at an initial combination open order credit limit of .1% (try for the best) and later adjust it. Sometimes a stock spikes up on market open or other situation and the order fills. So for .1% loss to close for the ALRM trade I would set the credit limit for the unwind at 60 – 0.056 = 59.94. (0.1% of 56.28 = .05628). For a 0.1% loss, your closing trade will only lose $5.63 per 100 shares.
Depending on your broker and the number of contracts purchased, the commission can affect your loss in similar proportion to the time value. For a single contract 100 share purchase and $10 combination commission, the loss per share is 0.10 which is another 0.2%.
Mario
This week’s 8-page report of top-performing ETFs and analysis of ALL Select Sector Components has been uploaded to your premium site. The report also lists Top-performing ETFs with Weekly options as well as the implied volatility of all eligible candidates.
New members check out the video user guide located above the recent reports.
For your convenience, here is the link to login to the premium site:
https://www.thebluecollarinvestor.com/member/login.php
NOT A PREMIUM MEMBER? Check out this link:
https://www.thebluecollarinvestor.com/membership.shtml
Alan and the BCI team