Covered call writing can be used in a variety of ways. Most covered call writers use this strategy to generate monthly cash flow. It can also be adapted to enhance the returns of a long-term buy-and-hold portfolio where some of our securities may have been purchased at a significantly lower price than current market value and sale of these stocks would create adverse tax consequences. This latter strategy is known as portfolio overwriting.
Differences between portfolio overwriting and conventional covered call writing
With portfolio overwriting our intention is to hold on to the stocks in our portfolio and avoid exercise of the options. We structure the strategy in a way that allows for continued share appreciation with additional profits earned from sale of the call options. To accomplish this we use only out-of-the-money strikes and move the strike price as far away from current market value to minimize the risk of exercise while at the same time achieving our option-writing goals. For traditional covered call writing we may use in-the-money strikes in bearish market environments and perhaps also use strikes not as far out-of-the-money if bullish. Option return goals are generally lower for portfolio overwriting than for traditional covered call writing.
Structuring a portfolio overwriting trade
Let’s say our long-term buy-and-hold portfolio has been generating an average annualized return of 8% and we want to enhance those returns by 6%. That means we are looking for returns of 1/2 1% per month or 1% for a 2-month return. Now we normally stay with 1-month options for the traditional strategy but when we are concerned about early assignment, ex-dividend dates must be accounted for. As a result, we may need to employ 2-month options for portfolio overwriting and I will explain.
Ex-dividend dates and portfolio overwriting
99% of the time, if options are exercised it will occur the day after expiration Friday (4 PM ET on the 3rd Friday of the month). To avoid this, we simply buy back the near-month option and sell the next month’s option. This is known as rolling the option…problem solved. However, there are times when an option will be exercised early and when that occurs it is usually associated with an ex-dividend date. This is the date shares must be owned in order to capture an upcoming dividend. The option holder (buyer) has the right to exercise the option any time before expiration to capture that dividend. When this occurs, it is usually the day before the ex-date.
How to avoid early exercise related to ex-dates
There are two ways to dramatically reduce the chance of early exercise related to ex-dividend dates:
- Write the 1-month call the day after the ex-date
- Write a 2-month call moving the contract expiration date much further away from the dividend ex-date
How to decide between 1-month and 2-month expirations: Real life example with AXP
With American Express trading at $52.96 (late January, 2016) and a goal of 6% per year on the option side, let’s have a look at a real-life 1-month options chain:
A goal of 1/2 of 1% would calculate to approximately $0.27. Let’s select the out-of-the-money $56.50 strike that earns a 1-month return of 0.60% and allows for an additional share appreciation profit of 6.7% (up to the $56.50 strike). This would make a great trade unless there was an ex-dividend date issue. Let’s check:
We see that the ex-dividend date passed in early January and so the 1-month option will work just fine.
What if the ex-date was due mid-contract?
If the ex-date is due the first week of a contract, we simply write the call option the day after that date. Had it been later in that contract month, we could have viewed the 2-month expiration. Let’s have a look:
This is actually a 7-week return and the $57.50 strike produces a $0.44 return which annualizes to 6.17% to meet our goal of 6%. It also allows for share appreciation to the $57.50 strike or an additional 7-week return of 8.6%.
With portfolio overwriting we use covered call writing to enhance portfolio annualized returns while structuring the strategy to avoid exercise and sale of our shares. This involves selling out-of-the-money call options that meet our return goals and factoring in ex-dividend dates. We favor 1-month options if there is no ex-date that contract month or if it occurs in the first week of a contract. If there is an ex-date that contract month that is projected after the first week, we use a 2-month expiration so that the contract expires well after the ex-date making early exercise much less likely.
Next live event
June 11, 2016
American Association of Individual Investors
Research Triangle Chapter
Raleigh/Durham, North Carolina
10 AM – 12 PM
Registration link to follow
- US retail sales rebounded in April, rising 1.3%, their biggest increase in a year
- March sales figures were revised higher to -0.3% from -0.4%
- The sales gains were broad based, though strong auto sales were a standout
- Retail sales bounce supports faster US growth in Q2 after a weak 0.5% growth rate in Q1.
- Germany, Europe’s largest economy, grew 0.7% in Q1, more than twice Q4’s 0.3% pace
- Eurozone growth was slightly less robust on a quarterly basis, growing 0.5% but on an annualized basis, the eurozone grew 1.5%
- Eurogroup finance ministers met this week to discuss debt relief for Greece. With the United Kingdom’s Brexit vote looming, ministers are widely expected to work out a deal for Greece so as to avoid a crisis that could provide ammunition to Britain’s “Leave” camp
- Brazilian president Dilma Rousseff has been suspended from office for up to six months while she is being tried in the Senate for violating fiscal laws to cover budget deficits
- Both the Bank of England (BOE) and the International Monetary Fund (IMF) warned this week that the UK economy will grow more slowly if Britain votes to leave the European Union
- In a letter to a US congressman, US Federal Reserve Chair Janet Yellen said negative interest rates cannot be ruled out as a possible policy tool in an adverse economic scenario but the Fed would use other tools at its disposal before resorting to negative interest rates
- Loan growth in China dropped 60% in April as Chinese authorities warned that the government intends to rein in debt-fueled stimulus. Local government bond issuance has been surging in recent months
THE WEEK AHEAD
- China reports retail sales, industrial production and investment data on Saturday, May 14th
- The eurozone consumer price index is released on Wednesday, May 18th
- The minutes of the April FOMC meeting are released on Wednesday, May 18th
- An account of the April ECB meeting will be released on Thursday, May 19th
- The UK releases April retail sales data on Thursday, May 19th
- The minutes of the April BOJ Monetary Policy Committee meeting are released on Friday, May 20th
IBD: Uptrend under pressure
GMI: 3/6- Sell signal since market close of May 4th
BCI: Neutral selling an equal number of in-the-money and out-of-the-money strikes.
WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US
Alan ([email protected])