Saturday, June 11, 2011

Double Dividends With Covered Calls

The covered call strategy should be every smallDogInvestor's first option strategy and lifelong friend. The reason is that there is a high success rate and very little downside risk. I like to use the covered call strategy on dividend paying stocks. The reason is that the payout of the dividend produces a predictable run-up and drop in the price of the stock. Here's how this works:

  1. Find a dividend paying equity. The DOW-30 and S&P 100 stocks are a good choice these days.
  2. Buy some shares about 30 days prior to the ex-dividend date. You will need to buy in multiples of 100 shares. If you already own a dividend paying stock that is profitable then use that. Round up your share ownership if necessary.
  3. Sell a front-month call(s) against your shares no later then closing bell the day before the ex-dividend date. I prefer to sell the first out-of-the money strike above my entry price if I can get a price equal to or greater than the dividend. The first in-the-money strike can be used if it is closer but still above your entry price.
  4. Once filled on the call, I place a GTC order to buy-back the calls for a nickel.
This works because investors are incentivized to buy stocks ahead of the ex-date AND short-sellers are disincentivized from shorting ahead of the ex-date. This latter bit occurs because short-sellers must pay the dividend on the shares they have borrowed if they hold the position through the ex-date. On the close of the last day of the dividend period the dividend is subtracted from the price of the last trade of the day and recorded as the adjusted closing price. The downward adjustment coupled with the shift in incentives for market participants often leads to a predictable drop in price in the first days of the new dividend period as a category of buyers disappears and a category of sellers are enabled. Properly executed you will collect both the dividend and the covered call premium. One caveat: some dividend runs peak a day or two before the ex-date, so look for toppy behavior and sell the call ahead of the must-own date.

7 comments:

  1. This comment has been removed by a blog administrator.

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  2. Hi AllenEv,
    Any chance you could post a real life example for us?
    Thx
    Jeff

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  3. Hi Jeff,

    I did post a real life example with ED : http://www.smalldoginvestor.com/2011/07/hedge-your-life-ed.html

    Also, Verizon has been a good one to sell covered calls on the eve of the divy.

    Best.
    -Allen

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  4. Hi Allen - forgive me for being concrete as a sidewalk, but what did you actually do there? That is, did you actually fill at 53? When? What day did you sell the call (which call?) on, at what price? Did you get called out or repurchase the call? Just kind of a newbie who needs to see how this actually works...
    Thanks!
    Jeff

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  5. Hi Jeff - here goes:

    7/20 bot 100 shares ED: $53.45 - ex-date on 8/15
    8/12 (fri) - ED sells off from 54.48 and Sep 55 calls not worth selling. Market Makers know the score and lower IV on the eve of the divy. No matter.
    8/15 (mon) - ED surprise rally on ED on ex-date
    sell SEP 55 call for .55/shr (divy is .60)
    9/15 roll SEP 55 call to OCT for .65/shr credit.
    10/19 roll OCT 55 call to NOV for .21/shr credit.
    11/4 bot back NOV 55 call for .06/shr loss because the call was ITM with < 5 cents of extinsic value with Nov dividend looming on 11/14 and out-month 55 CALLS not worth selling.
    11/14 ED pays .60/share divy
    11/17 sold DEC 60 call for .35/shr credit.
    11/23 bot back DEC 60 call for .05/shr.
    12/8 sold JAN 60 call for .65/shr

    The upshot is to keep rolling the call. Even if it is a little ITM, you can still collect some more premium on the roll. This gives you more time to buy back on the cheap when the stock eventually pulls back.

    Buying back for the 6 cent loss was a stroke of luck which I parlayed into upgrading to the 60 - strike calls. ED is a regular divy increaser so this $60 level should be rich in premium for some months.

    Best.
    -Allen

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  6. Hi Allen,
    Thanks! That's very helpful. When you "roll the call" do you actually sell the one and buy the other? Or does the broker actually let you swap these on one transaction?
    Rgds,
    Jeff

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  7. Hi Jeff,
    Yes, when I "roll the call" I am buying back the near-dated call and selling the far-dated call in a single transaction. The broker will quote a credit that is equivalent to the difference of the current mark (mid-bid/ask) prices of the two options. ThinkOrSwim charges me a fee based on the number of options in the transaction. Their bulk-rate starts to kick-in (over the standard single-contract rate of 2.95/per)when rolling four or more calls.
    Best.
    -Allen

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