Thursday, April 21, 2016

Market timing with covered calls

Microchip Technology on trade fair Embedded Wo...
Microchip Technology on trade fair Embedded World a few minutes before opening the fair, Nuremberg, Germany 2008 (Photo credit: Wikipedia)

One of the many ways to use covered calls to manage your stocks is to use them to get rid of a stock.  


You should have a good reason to get rid of a stock because when you use covered calls with the idea of being assigned (the call buyer exercises the option and buys your shares) it happens a lot.  You do not want to use this strategy on stocks you will be sorry to lose.

This technique is really a timing mechanism.  I think the stock market seems a little expensive based on P/E ratio.  Times are uncertain locally and globally.  I lighten up on stocks that no longer meet my dividend stock selection criteria with emphasis on stocks that are over valued by P/E (price earnings) ratio.   Microchip Technology, MCHP is the stock I am writing about today.

Dividend Machine Fundamentals to decide which stock to sell.

I started using only four criteria to pick a Dividend stock and in 2016 I added two criteria.   My first four metrics were (1) EPS greater than dividends paid out (2) dividend yield of 3% (upped to 3.5% in 2014), dividend growth rate year over year (minimal 5 year growth rate upped to 4% in 2014), and D/E or debt to equity ratio of 1 or less or equal to industry standards.

In 2016 I lowered the dividend yield minimum to 2.75% but added two criteria (1) revenue growth over the past 3 years of at least 4% and (2) availability of covered call options that would yield at least 1% on each contract and a minimum of 8% capital gain over basis should the call be assigned.  In other words, the strike price has to be 8% greater than my basis.

Microchip Technology Dividend Stock Fundamentals

Microchip Technology (MCHP), my very first Dividend Machine, is still in my personal portfolio and I have been working the calls and receiving the dividend.  Now I am working the calls to get rid of Microchip.

Microchip violates two of my key criteria: it has a D/E ratio of 1.38 which is too high and the dividend growth rate is to low.   Moreover, I think the market may be overvalued and I think MCHP is ripe for selling because the P/E ratio is 30.38.   

MCHP's stock price appreciation has been quite good since I initiated a position in November of 2010.  My first buy was at $33.55.  MCHP trades to day about $49.50 for quite a nice gain.  My personal basis is $34.93.   The dividend yield is 2.95% which isn't bad but the dividend growth has been a tepid .869% per year which is another reason to dump it.

In an effort to grow, MCHP, bought another company, Atmel and is working through the process of making money from that acquisition.  I don't use that kind of news to make my decisions about dividend stocks.  I just don't know enough about it.  I stick to my fundamentals.

However, for those knowledgeable about the acquisition, you may be willing to wait for the acquisition to pay off.  Analysts think that indeed MCHP will grow and project a forward P/E around 18.  Due to the debt and slow dividend growth, I am still wanting to get rid of MCHP

Getting rid of MCHP with Covered Call Options

Now take a look at the list of calls that I have used to boost my income and more recently to try to get rid of MCHP.

As time progressed and I realized that that their debt was increasing and the dividend was not, I wanted to get rid of it so I sold calls very close to the current trading price.  So far, I have had no takers on my last 200 shares but I will continue to try.  You will see that I just sold May 20, 2016 calls for $.95 a contract.  Notice that the range of call premiums was $.55 to $3.80.

Actual MCHP Covered Call Experience

Covered call premiums on the 300 hundred shares in my Dividend Machine Portfolios have been good and all three hundred shares would have been assigned.  I bought at the same time I wrote about MCHP.  I personally bought 500 shares.  300 of my shares were assigned as they would have been in the model portfolios and I am left with 200 shares.

My basis on my remaining 200 shares is  $6,986 or $34.93 per share.  My basis on all 500 shares is $17,465.   My income from MCHP covered calls so far is $2,365.  Covered calls added  13.54% to my income.   That does not include dividends.

Strategy Keys

The key to this strategy is to select a strike price very close to the selling price and with an expiration date no greater than 30 days out.  You don't want to wait around while the stock price deteriorates to meet the deteriorating dividend fundamentals.   I sold my most recent call on April 19 with an expiration date of May 20. 

You want a really good premium.   If the call expiration date is before the next ex-dividend date, you want the premium to be even richer.   I like a minimum of 1 % plus the amount the quarter dividend that I may lose out on.  The most recent call premium was $.95 or 2.7% on my basis and 1.9% on today's price.

This is an example of how to use covered calls to time the market and get out of a stock that for one or more reasons seems over valued or under performing as a dividend machine.

M* TheMoneyMadam 
Disclosure:  Long MCHP with calls