Monday, March 2, 2015

Covered Calls have more advantages than bonds

I used to be a bond girl.    Interest rates were uber high and you could double your money in just 5 years.   

You did not have to be brilliant to ladder a portfolio of bonds.   You could sleep at night.  It was so much fun.  Moreover, every bond bought at par or less at some point traded above par as the bull market in bonds developed.     

But now bonds are just simply too expensive.  Occasionally, you can find an investment grade bond with a five plus percent yield to maturity for 5 years that sells at a discount, but you do not want all your money in a bunch of 5%, 5 year barely investment grade bonds. 

Now I am a covered call girl.  I want to be perfectly clear here, I do not trade options.   Trading options is an entirely different animal.   I sell covered calls. Selling covered calls is sometimes called writing covered calls.   The key word in that description is “covered.”   This strategy is based on owning the stock.   You don’t trade the stock or the option.   You simply sell to another the right to buy your shares at a given price within a specific time frame.  It is a stock ownership strategy not a trading strategy. 

Benefits of Covered Calls in an income portfolio

Benefits from using covered calls are not limited to just boosting income.   Other benefits include, capturing capital gains, maintaining a minimal yield level, and passive portfolio rotation and diversification of your portfolio holdings.  Selling calls is a lot of fun too. 

Boost Income
Boosting income is the easiest benefit from selling covered calls to understand.   In 2015 income is hard to come by.  All asset classes are expensive.   Most income investors are also very conservative investors who don’t want to lose their “principle.”    Right now, selling calls on quality dividend stocks that you own is easy to do and this strategy makes sense.

Not every dividend stock has covered calls but many do.   You have to look often to find the right call on the right stock.  A call I like will pay about 1%.   Sometimes you can get more than 1%, but I don’t like to settle for much less than one percent.    This 1% number also makes it easy to select the call that works for you.  If a stock is priced at $50, you want your call income to be $.50.  

Timing is also important.  Each call has an expiration date.   Make sure your covered call expires after the next ex-dividend date.   The reason is to make sure you are receiving both the dividend and the call income.  

Remember that most calls expire without any action, but should your stock be assigned or “called away,” and you do not get the dividend, you have missed the whole point of the strategy.  Conservative income investors need to receive both the dividend and the income from the call.

Stocks are not like bonds.  If you sell a bond prior to maturity, you get the interest for every day you own it.   With dividend stocks, you have to own it on the ex-dividend date to receive that quarterly dividend.  You don’t want to accidentally have your stock taken by the call buyer because the call expiration was earlier than the ex-dividend date.

Capture Capital Gains

How often have you owned a really good dividend stock that goes up in price and you want to capture those capital gains yet you don’t really want to sell the stock?    Quality dividend stocks go through cycles.   Sometimes they are stagnant and sometimes they move up.   When they are on the move they can be on a tear and you find that all of a sudden instead of earning three plus percent dividend yield, you’re only getting 2% or so.    And, you might tell yourself, that you don’t want to risk losing that gain so should you sell?

This is a conundrum.   You really don’t want to sell the stock especially if it is a stock that raises the dividend substantially every year.    But you would really like to take the money and put it in something that yields more.   Cashing out a gainer to get more yield makes sense.   I have read several articles that evaluated if it is better to put your money into higher yield versus high dividend growth.   For income investors higher current yield wins and the older you are the more you need current yield.  In other words you need to preserve your capital gains and move them into higher yielding stocks.

Sophisticated investors use another option strategy to lock in capital gains but that is not part of this strategy.   However, you can use covered calls to capture capital gains and here is how that works.

I usually sell my covered calls with a strike price that is no lower than 10% above my cost basis.   But the scenario I write about here, where you have a big capital gain, your cost basis could be 50% or more below where the stock is now trading.  You bought at $20 and it is $50 now.

When you decide to risk losing a really good stock that has appreciated so much that your yield is too low, you can ignore the 10% rule and sell a covered call with a strike price that is just above the trading price.  In other words, you want the buyer to take your stock.    You can also suspend the rule of an expiration date after the next ex-dividend date.   You make extra income with a call that is not so far out and is close to the current stock price.   You get income and capture your capital gain.   If your position is large enough, you could consider this move on a portion of your position.  Now you are free to take your gains and invest in a Dividend Machine or another dividend stock with growth potential.

An example of this is DuPont (E.I. du Pont de Nemours and Company,) symbol DD.     Basis is $47 January, 2012 with an original dividend yield of 3.5%.  Today, DD sells at about $78 and the yield is only 2.4%.   You could sell an April, 2015 $80 call for $.92. Your yield on the call plus the capital gain is very impressive.  I want them to take it so I can capture my gain and move it into a higher yielding stock.  If they do not take it, I will look for another call after this call expires.

Maintain minimal yield

In 2015 where income is hard to come by, you need every basis of yield you can get from your assets.   I like to average about a five percent yield on my income stocks.   I cannot accomplish that just from dividends.   You would find your portfolio to be poorly diversified and narrow if you only buy stocks that yield five percent or more.   Yet you can get that income when you employ a strategy of covered calls on dividend stocks.

For instance if you own Apple, symbol AAPL, your dividend yield at today’s price of about $130 is 1.4%.   Hard to live on 1.4% but you could sell calls on your AAPL stock and boost that income.  Depending on the strike price and expiration date, you could easily get another 1% twice a year to make your income from AAPL closer to 3.4%.     

However, one of the risks of using a covered call strategy is that sometimes the call buyer actually takes your stock.    It can feel awful to lose a great stock and watch it continue to go up.  Knowing that current yield is more important to an income investor’s success than is either stock growth or dividend growth makes this more palatable.

Comb through your income portfolio and when you see a stock that is yielding less than 3% look for a call that has the following three criteria:  strike price 10% above the current price, call premium of at least 1%, and an expiration date after the next ex-dividend date.  If you could do that twice a year, you could enhance your income significantly.  

Portfolio rotation/diversification

My theory of income investing includes the idea that “there is always another stock to buy.”  I suffer over stocks I sold that continued to appreciate like everyone else but I must concentrate on yield and so I use the covered call strategy to sort of force me to sell my winners.

This liberation of capital makes me seek a new higher yielding stock and it allows me to diversify by rotating into different sectors and diversifying by capitalization, or industry, etc.

Stocks move into and out of the realm of Dividend Machines all the time.   Often a high yielding stock is in an industry that is weak.   Energy would be a good example for 2015. 

Again, you have to look through your portfolio and look for dividend stocks that will add a measure of diversification without dispensing with your income principles.

Consider learning how to sell covered calls on your dividend stocks to maximize your portfolio performance. 


Disclosure:  Long AAPL, Long DD, covered calls on both stocks