Covered call writing is a conservative strategy that encompasses a great deal of inherent application flexibility. In my first 3 books and DVD Programs I have discussed the use of LEAPS as a stock surrogate, protective puts, the use of cash-secured puts to enter a covered call trade at a discount and portfolio overwriting. In this article I will review the use of covered call writing as it relates to portfolio overwriting and present a more detailed approach than I have in the past. My motivation for writing this article is based on a number of requests from our members to provide more information on this topic so thank you for the suggestions and here we go.
Portfolio overwriting is a strategy we use to enhance the returns of a buy and hold portfolio. We sell out-of-the-money, 1-month call options targeting a specific additional annualized return. For example, if we wanted to increase our portfolio annualized returns by 6%, we would write calls that generated at least 1/2% per month. The fact that we are writing out-of-the-money calls, we would also allow for share appreciation. In essence, we want more money and do not want our shares sold. For some, share retention is for psychological reasons (you’ve become attached to your stock…almost like a family member!) but tax consequences due to a low cost basis is the major overriding concern. Of course, if you are trading in a sheltered account, there are no tax concerns and you can be more aggressive in your approach than detailed in this article.
99% of the time, exercise of a call option (your shares are purchased as per your option obligation) will not occur until the day after expiration Friday but there are rare exceptions of early exercise which I will address. First let me explain the reasons why options are rarely exercised early:
- A call holder can keep the cash in an interest-bearing account until the last minute rather than spend the money “early” prior to expiration Friday
- Early exercise is exposing the call buyer to greater risk as the cost of the shares is much greater than the cost of the option
- The most important reason is the loss of time value of the option. By exercising an in-the-money option, the holder is capturing intrinsic value only (difference between current market price and strike price) but leaving time value on the table. The call buyer is usually much better off selling the option and ending up with a higher return
In these cases where early exercise does not occur and the strike is in-the-money (even by $0.01) we can roll the option (buy it back and then immediately sell the next month’s option) prior to 4 PM EST on expiration Friday and avoid the sale of our low-cost basis stock. The most common exception to this rule relating to early exercise occurs when there is a dividend distribution from the underlying security (keep in mind that not all stocks distribute dividends but many high quality equities do). In these cases, early exercise is more likely when:
- The ex-dividend date (date you must own the shares in order to collect the dividend) is close to expiration
- The call strike price is in-the-money (lower than current market value of the stock)
- The dividend is > the remaining time value of the option
So what can we do to avoid early exercise in these cases?
The easiest way to circumvent this issue is to avoid selling options the 4 times per year when the ex-date is approaching until the day after that date. For example, if BCI’s ex-dates are January1, April 1st, July 1st and October 1st, on those months we hold off on writing calls until the 2nd of those 4 months…problem solved. Granted the returns will be a bit lower those months but early exercise will most likely be avoided. The reason I say “most likely” is because there are traders out there that may exercise early even though it will cost them money. It’s the wrong move but may have an impact on us…this is rare and unlikely but possible. Here is a free link where ex-dates can be accessed:
Here is a screenshot showing the ex-date for American Express:
Another strategy that can be employed to minimize the risk of early assignment is to sell a 2-month option during the month of the ex-date. For example, after the December contracts expire and there is an ex-date on (for example) January 10th, sell the February contract rather than the January contract. This way the option holder is much less likely to consider early exercise because the time value of the option is much greater and there is a much greater exposure to share ownership because of the longer time frame. As a guideline, if the ex-date is in the first week of a contract, sell that month’s contract the day after that date. If the ex-date is later in the contract, sell the next month’s option (2-month option) right after the previous expiration.
Buy and hold portfolios, especially those with a low cost basis, can be enhanced using a conservative covered call writing strategy. It entails writing out-of-the-money calls based on our annualized goals. To avoid exercise, rolling strategies and avoidance of ex-dividend dates must be accounted for. It is also important to speak with your tax advisor should early exercise occur…it may not be a financial concern based on other investments in your portfolio.
***In part II, I will set up a hypothetical portfolio using popular blue-chip stocks to illustrate one way to utilize this covered call-like strategy.
Kindle version of Stock Investing For Students Now Available:
A shortened holiday week resulted in only a few key economic reports:
- The Conference Board’s index of consumer confidence (a gauge of consumers’ attitudes about the present economic situation as well as their expectations regarding future conditions. Consumer confidence tends to have a strong correlation with consumer spending patterns) dropped to 70.4 in November, the lowest level since April
- Housing permits rose by 6.2% in October, the highest level since June, 2008. This represents an increase of 14% from October, 2012
- New orders for durable manufactured goods declined by 2% in October, worse than expected
- The Conference Board’s index of leading economic indicators (a composite index of ten economic indicators that typically lead overall economic activity. The index includes indicators such as housing permits, new orders for consumer goods, consumer expectations, and performance of the S&P 500 Index) increased by 0.2% in October, above expectations and the 4th consecutive monthly gain
- Initial jobless claims for the week ending November 23rd came in at 316,000, below the 330,000 anticipated
For the week, the S&P 500 rose fractionally for a year-to-date return of 29%, including dividends.
IBD: Confirmed uptrend
BCI: Moderately bullish favoring out-of-the-money strikes 2-to-1
A holiday message to our members:
For me and Barry and the rest of the BCI team sending holiday wishes does not seem quite adequate. Seven years ago when The Blue Collar Investor concept was launched and my first book published we had a dream aspiring to reach as many retail investors as possible and make a difference in their lives. We were not Wall Street Insiders but rather blue collar workers and investors just like you. By ourselves we had the ability to achieve some success but with you and thanks to you we have reached levels we never dreamed possible. Atop the foundation of your loyal and supportive membership of thousands throughout the world reside the Blue Collar team. With you we stand tall having achieved a lifetime of dreams; without you we are simply a group of hard-working people with an idea. The English language hasn’t yet created the vocabulary to adequately express our gratitude to all who have helped bring the Blue Collar Investor the notoriety it enjoys today.
Happy holidays to all,
Alan, Barry and the entire BCI team