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| KNRM Caterpillar CAT (Photo credit: Wikipedia) |
Caterpillar
is the perfect stock to demonstrate how covered calls can boost your income and
to discuss the risks associated with this type of strategy. In
this post I will explain why CAT is a good stock to consider for this strategy,
the risks of investing in CAT, and how to use the covered call calculator to
determine what I expect to gain.
Why Caterpillar has been a good stock for income.
Caterpillar, symbol CAT has been around a long
time. It makes a lot of money; it is a
solid company in that it manages it debt and its business very well; CAT shares
income with its shareholders and has increased the investor income every year
for over 10 years.
Going back to 2005, after CAT split the stock, you
would have received $.25 per share in a quarterly dividend. Today, those same shares pay $.52. When you income more than doubles over eight
years, you have a good income stock.
What risks exist using Caterpillar?
You risk CAT’s stock price going down, simple as
that. The risk that CAT will reduce or
(gasp) eliminate the dividend are very small.
Even during the market crash in 2008-2009, they continued to increase
the dividend. But during that time the
stock price moved violently. Let’s look
at a few data points.
April 18, 2005 $41.79 three years later the price
has gradually increased to April 17, 2008 $78.59. On March 2, 2009 the price hit a low of $22.17. If you bought in April of 2008, you would
have lost three quarters of your principle.
Yet your income would have continued and increased every year. If you bought in March of 2009, you would be
considered brilliant because CAT hit a high of $116.20 on February 23,
2012. Your principle would have
increased fivefold.
Your risk, if you buy CAT today at around $80.81, is
it could go down to $22 again. Only you
know if you have the courage to take that risk.
What do I expect to gain?
By adding CAT to my income portfolio, I obviously,
expect to add a source of steady and increasing income. I also expect to boost my income by selling
covered calls on the shares I own. You must have a minimum of 100 shares to sell a
covered call. To review what a covered
is: another person pays you for the
option of buying your stock at a specific strike price with a set amount of
time. They do not have the obligation
to buy it but you have to sell it to them at the strike price is they decide to
exercise their option. When they buy it,
it is considered “assigned.” The point
of the covered call is you get to keep the premium, the money they pay you for
the option, no matter what.
Use this table to learn how to determine your gain.
CAT Aug 2013 Call
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Results If Assigned
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||||
Strike Price
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$
90.00
|
 |
Cap. Gain
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$9.19
|
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Basis
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$
80.81
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Strike Price - Price
Paid
|
|||
Call Amount
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$
1.10
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Prem Yield
|
1.36%
|
||
Call Amt/PricePaid
|
|||||
Dividend
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$
1.04
|
Total Return
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14.02%
|
||
Must own on April 22
and July 20
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Cap Gain+Call
Amount+Dividend/Basis
|
||||
The left table includes the data you need to
determine your potential gain. You need
to know the strike price of the call, you cost basis, the call amount which is
what you receive, and any dividend that you are entitled to provided you own
the stock at the ex-dividend (sometimes called the effective) date.
The right table calculates your return. Cap. Gain is the gain you would receive
based on buying the stock at $80.81 and selling it at $90.00 so you subtract
the basis from the strike price.
Premium yield is the call amount of $1.10 divided by the basis expressed
in percent. Total return add all the
gains, the capital gain, the call amount and the dividends ($9.19+$1.10+$1.04 =
$11.33) divided by the basis of $80.81.
Total return is expressed in percent.
$11.33 divided by $80.81 = 14.02%.
I have used CAT as an income investment many times. It is rarely a dividend machine because the
stock tends to be high enough that the yield is less than my three percent
minimum. However, if Caterpillar’s
stock price continues to deteriorate, it may become a dividend machine. CAT’s stock price would have to go down to
around $68 to be a dividend machine. I
would rather it stays in the $80’s and goes back up to $116 while we cash our
dividend checks and our deposit our call premiums.
TheMoneyMadam
