Wednesday, April 17, 2013

Caterpillar Covered Call - An explanation of how to create income!

KNRM Caterpillar CAT
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

Results If Assigned
Strike Price
 $        90.00
Cap. Gain
 $        80.81
Strike Price - Price Paid
Call Amount
 $           1.10
Prem Yield

Call Amt/PricePaid

 $           1.04

Total Return
Must own on April 22 and July 20

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.


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