Thursday, October 28, 2010

IBM Growth and Income Machine

Selling Covered Calls - an illustration for income investors.

TheMadam has always considered the income from writing covered calls a gift.   But there are criteria that should be employed when using this strategy to supplement your income.

One of my rules, as you may recall from my website, is to always invest your money in an instrument that pays you something while you hold it.   For both my income portfolio and my growth portfolio, I always try to employ that rule.

Covered calls are no exception.  When you write or sell (these terms are interchangeable) a covered call you covey the right to buy your stock to another person at a certain strike price and within a certain time frame.  You must remember that the person who buys your call does not have to buy your stock from you.  The option is totally the buyer’s.  Therefore, you always want your underlying stock to be a good one.  The stock should make money, have no more debt than other companies in its industry and pay you a dividend.

In October of 2008, I decided I wanted to own IBM.  At the time IBM paid a dividend of $2 per share per year and at the price I paid (100 shares at $81.60 and 100 shares at $77) the dividend yield was about 2.5%.   Now 2.5% is only ½ of the yield that I count on for my income portfolio so I need to make more money on either call premiums or capital gains from selling the stock to meet my goals.   But IBM has a history of increasing its dividend over time so that fact was a positive.  And its debt to equity ratio was within the range of comfort.  Further more, if the market tanked again like it did in March of ’03 I was pretty sure IBM would not go out of business.  You always want to be comfortable with the underlying stock in case you are stuck with it for a while.

IBM also seemed to be a good pick for my growth portfolio.     I have bought and sold IBM several times over my investing career and I was ready to buy again.  I decided not to reinvest the dividend because I needed the income to live on and I decided to write calls on it at ever increasing strike prices.   I was confident that the dividend, plus the call premium would more than meet my 5% income goal and I was also confident that if the purchaser of my call wanted IBM at the strike price that I would receive enough capital gain to meet my growth goal of 7%. 

Listed below are the actual transactions over the past 14 months on those two IBM buys.  So this is not just an illustration, is it actual history.

     10-27-2008  Buy 100 Shares net cost                       $8,258.95
     11-19-2008  Buy 100 Shares net cost                       $7,708.95

     Total amount invested                                              $15,867.90

    Income from dividends
        3-10-2009    $ 50.00
        6-10-2009    $100.00
        9-10-2009    $  55.00
      12-10-2009           $  55.00

    Total income from dividends $260.00

    Income from writing calls
        10-27-2008    $390.29  strike price  $85
        11-19-2008    $290.29    strike price   $85
        11-24-2008    $265.29  strike price  $90
        01-26-2009    $135.29  strike price $100
        01-28-2009    $150.29  strike price $100
        03-23-2009    $100.29  strike price $110
        04-02-2009    $  80.29  strike price $115
        07-13-2009    $ 95.29   strike price $110
        07-27-2009    $100.29  strike price $125
        10-12-2009    $ 95.29   strike price $130
        11-04-2009    $ 96.29   strike price $130
        12-21-2009   $139.29  strike price $130

    Total income from calls     $1,938.48

Capital gains from sale of first 100 shares when the buyer of the call exercised their right buy at $110.

Total gain from sale           $2,831.81

My income yield over this 14 months has been 13.85 % well exceeding my 5% goal and the capital gain of the most expensive 100 shares was 17.85% again well above my growth goal.

Moral of this story is covered calls are an excellent strategy for income investors provided you invest in an underlying stock with great fundamentals.  Please note,  this is not a recommendation to buy IBM stock especially since it is selling at just about it’s all time high.  If my last 100 shares gets taken, I would be thrilled because there always another stock to invest in and write calls.
Very Truly Yours,