Comfort with Covered Calls?

[Kerim]

Ok, I'll kick off this new options area by asking about how folks think about using covered calls with their dividend growth portfolios. I am intrigued by the strategy generally, but am just not sure how it is compatible with building a big portfolio, and a growing stream of income, over the years. Doesn't the specter of having your shares called away make it hard to build and track that portfolio?

[hendi_alex]

As posted earlier, I don't sell calls in my small but growing long term dividend portfolio. I do know investors who do sell some calls, but it is relegated to 'trading around the edges', basically buying shares in excess of a core full weighting and then selling out of the money calls until the excess shares get taken out. Then either selling an equal value of puts or waiting until the shares move back into the buy range. Swinging between calls and puts for a set position can generate a very nice income stream, especially during times that the share price is range bound for an extended period. IMO using a portion of the investment dollars to take advantage of, to trade the volatility, can increase performance, as long as the play is limited to stocks that the investor would normally want to hold long term anyway, and provided that the activity doesn't get weighting stretched to over sized extremes.

[ChadR]

I do both covered calls and cash secured puts. Currently the only covered call that I have open is 2 on WIN for Jan at $9. WIN is a speculative play/yield chaser. Bought 200 shares for $8.50 a month back and then sold the call at $9. This way I would make a little money on the shares and receive 2 dividends.

I only sell covered calls on speculative plays or on positions that I think are overvalued. I sell cash secured puts on positions that I want to have and would love to buy, but at a little cheaper price. This is probably one of the more conservative option trading strategies, but it lets me sleep at night. Also much less work with this strategy. And I don't use margin when trading options. Too risky in my book.

[jmjor]

I toyed with covered calls for awhile. I read somewhere that 80% of all options expire worthless, so why not give it a shot. At first it worked out well, I sold the options, the market went down, either none were called or the ones that were I could almost immediately buy back at a discount (lucky!). I felt like I was so smart. Then I sold a new batch, the market went up and I missed out on very nice capital gains which I found out really bothered me. So I basically quit the practice except only rarely when I have a stock I've decided I wouldn't mind selling.

[Kerim]

That sounds like a pretty good approach, jmjor. If I decide to lighten up my INTC holdings even more, maybe I'll use covered calls to do it.

[mjs_28s]

(09-26-2013, 07:06 AM)Kerim Wrote: Ok, I'll kick off this new options area by asking about how folks think about using covered calls with their dividend growth portfolios. I am intrigued by the strategy generally, but am just not sure how it is compatible with building a big portfolio, and a growing stream of income, over the years. Doesn't the specter of having your shares called away make it hard to build and track that portfolio?

One thing to consider to nearly eliminate your chances of being called out of positions is that as your portfolio grows the smaller premium you can rake in and have that smaller premium matter.

For example - if you have $25,000 of your portfolio that you use for CC writing you probably use one strike OTM or ATM to get a nice cash flow, which would make sense (if you are using monthlies as I do). These strikes will typically give you 2-4% depending on how you pick your stocks. Small premiums for further OTM calls barely make money over commissions.

But if your CC portion of your portfolio is say, $250,000, rather than trying to target 1 strike OTM or ATM you can move out to 2 strikes OTM. While the premiums are smaller you are doing this with more contracts per commission thus you can accept a lower premium return and do ok. With $250,000 if you are will to accept 0.4% per month, $1,000 cash flow, that means your strikes are far enough OTM that you will hold 95% of the time. IF you are doing this with dividend paying stocks you turn a 3% yielder into a 3% + (12 months * 0.4%) = 7.8% cash flow machine with very small risk of being called out. Nice thing to is that if you do get called out 2 strikes OTM, on a mega cap stock that pays dividends, you are still going to pull in a cap gain around 2 to 5% for one month, plus the premium.

While the 0.4% on $250,000 is much to small for some CC writers, I look at it as $1,000 per month extra income to direct to other investments (typically my core holdings) that I would not otherwise have. $12,000 adds up pretty quick.

Just think, when you get your CC portion to $500,000 you could reduce your acceptable premium percent return per month and still coin $1,500 per month to invest elsewhere.

Covered Calls only get sexier as you get more money to do them with as you can accept lower premiums on strikes farther OTM that what most people write. If you do it with stocks that already pay dividends you can create quite a nice cash stream with very tiny risk of being called out.

Good luck with your option writing!

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(11-08-2013, 03:07 PM)jmjor Wrote: I toyed with covered calls for awhile. I read somewhere that 80% of all options expire worthless, so why not give it a shot. At first it worked out well, I sold the options, the market went down, either none were called or the ones that were I could almost immediately buy back at a discount (lucky!). I felt like I was so smart. Then I sold a new batch, the market went up and I missed out on very nice capital gains which I found out really bothered me. So I basically quit the practice except only rarely when I have a stock I've decided I wouldn't mind selling.

One thing to try in markets moving up after a drop is to ladder calls. Maybe write some 3 months out fairly far OTM, some 2 months out two strikes OTM, and 1 month out 1 or 2 strike OTM.

This way even though some stocks get called out you still have 1/3 of you CC portion coming due for rewriting or doing new buy/writes if called out.

"That sounds like a pretty good approach, jmjor. If I decide to lighten up my INTC holdings even more, maybe I'll use covered calls to do it."

That is a good idea too. When I knew it was time to take some profits but I was fighting an emotional affair with certain holdings I would sell ATM calls for parts of them to trim out in an unemotional way. If I was wrong, well I just had the same positions to write more calls on.

[Kerim]

Hello mjs_28s! Welcome to the forum!

That's an interesting insight about using covered calls in a small versus large portfolio. I'm a pretty long way from having that kind of money to deploy as part of an options strategy, but I am enjoying the learning!

[mjs_28s]

(12-14-2013, 03:20 PM)Kerim Wrote: Hello mjs_28s! Welcome to the forum!

That's an interesting insight about using covered calls in a small versus large portfolio. I'm a pretty long way from having that kind of money to deploy as part of an options strategy, but I am enjoying the learning!

You'll get there. Nice thing about compounding is once that compounding snowball gets to rolling nice....oh yeah...

[NilesMike]

(09-26-2013, 07:06 AM)Kerim Wrote: Ok, I'll kick off this new options area by asking about how folks think about using covered calls with their dividend growth portfolios. I am intrigued by the strategy generally, but am just not sure how it is compatible with building a big portfolio, and a growing stream of income, over the years. Doesn't the specter of having your shares called away make it hard to build and track that portfolio?

While I will sell calls and puts, they are naked and outside of DGI portfolio in general.

My experience has been that the DGI stocks that we typically seek to own do not have enough volatility to make covered calls a viable strategy, except as an exit/entry to a position.

None of the DGI stocks in my portfolio currently pay enough, at the 95% OTM expiration strike, to make it worthwhile.

Even MO, I own PM, that has high implied volatility has a Jan14 call @95% OTM (strike price $40) that will pay 3 dollars per contract (100 shares, $3,700 in stock value).

Maybe mjs could give some examples?

Good luck to all.

[mjs_28s]

I may not have examples that satisfy your use of CC writing. It sounds like you are after a much higher premium than what I am after. As stated in my longer post, in short, I don't mind skimming nickels and dimes. Since my CC portion of my portfolio is significant enough skimming even 0.3 to 0.4% per month is productive.

Some of the stocks that are on my list that might work from now until Jan 18th 2014 expiration include the following. I am NOT including any dividend income in the ones below, only option premium. The list is also not any kind of endorsement to buy or sell. They are just some from the list of stocks that I watch for CC writing and that I may or may not hold at the moment. Share and option strikes are from close Dec 13th.

Abbott Labs (ABT) Price $36.40, two strikes OTM, $0.19 - income return 0.52%. Annualized 6%. If current 2 strikes OTM called: 4.4% cap gain + premium = 4.92% gain if called. Current Div 2.3%

Abbvie Inc (ABBV) Price $52.37, 3 strikes OTM, $0.25 - income return 0.43%, Annualized 5%. If current 3 strikes OTM called: 9.80% cap gain + premium = 10.23% gain if called. Current Div 3.3%

AT&T (T) Price $33.85, 2 strikes OTM, $0.20 - income return 0.59%. Annualized 7%. If current 2 strikes OTM called: 3.4% cap gain + premium = 4% gain if called. Current Div 5.4%

Dow Chemical (DOW) - (this one volatile) Price $41.52, 4 strikes OTM $0.29 - income return 0.69%. Annualized 8%. If current 4 strikes OTM called: 8.4% cap gain + premium = 9.9% gain if called. Current Div 3.1%

Intel (INTC) - Price $24.29, 2 strikes OTM $0.15 - income return 0.6%. Annualized 7%. If current 2 strikes OTM called: 7% cap gain + premium = 7.6% gain if called. Current Div 3.7%

Proctor & Gamble (PG) nice and boring. Price $82.37, 2 strikes OTM $0.58 - income return 0.7%. Annualized 8%. If current 2 strikes OTM called: 3.2% cap gain + premium = 3.9% cap gain if called. Current Div 2.9%.

In total I track around 40 to 50 stocks, all dividend payers. Also, the premiums above are from Friday when the markets were essentially flat. On down days & flat days the premiums are clearly going to be lower than on up days. So any other day this is checked could be higher or lower for the income streams.

For me, I do not really hold out all that long for up days since one month options can lose quickly to time and since I am just going to redeploy the option income to another part of my portfolio, the core, I don't really worry about how much the actual dollars end up being. Also, since I am reinvesting the premiums (and dividends) into my core holdings that I don't write options on I don't really worry about getting called. Of course, why would I complain about 3% to 5% (typical the near 10% for DOW is a rare event in my list and thus indicates higher speculation). And since I have a core portfolio that is always invested if I get called I didn't really miss any run of the market as a whole. Just on maybe a specific position or two on the option side but with the 2 strikes OTM I am pretty much promised a nice monthly return if my shares are taken from me, assuming I don't close the position and roll out or out and up for the next month.

My purpose for CC income is to always have a little extra stream of income for investing. I am not after huge premiums like I used to be as the risk was not quite worth it when you end up being wrong. However, sticking to the boring mid to large cap blue chip type stocks I get what I want. In most cases it is taking a nice dividend paying stock, doubling the actual dividend income with low risk of having to take a capital gain.

Specifically to MO, that is one that I have to trade ATM or one strike OTM to get any premium that made it worth it. For MO, and stocks like it, you may have to move out a few months rather than monthlies. In the case of MO you can write Mar 2014 $39 strikes for $0.26 - 0.7% premium. Annualized 2.5% with a capital gain if called of 5.1% + premium - 5.8% total gain, or right at 20% annualized gain if called. Not too bad but several months out like that, 99 days I believe, you have to know for sure if you want to let it get called and move on so you don't make a costly choice and possibly close out the option if it moves up. Since MO likes to run in a range, it seems but I am often wrong, you can sometimes buy it back for less than it was called away and then write options on it again.

An example of letting a stock go that you might like and then being able to buy it back later when it comes back down a little is Verizon.

I bought 500 shares of VZ at $48.90 (april 2013) and sold options on it three times for a total premium $0.78 or 1.6% total. I received dividends that came in around $1.50 or another 3% and then a tiny $0.1 cap gain. Basically, it was a very boring 5.2%ish gain for six months BUT the stock was flat that whole time, the dividend was 3% that I actually bumped my income to 5.2%. In a nutshell I had the same benefit as other VZ holders in addition to the extra 2.2% income that I added to my core holdings that have much better gains than VZ does. VZ also closed at $47.84 on Friday, or 2.4% less than what it was called away from me. Buying it on Friday and writing a $49 Jan strike would bring in $0.45 (if you don't get the dividend as well of $0.53) for a premium of 0.9%. If you managed to get the dividend as well you are talking about a cash flow of 2% and capital gain of 2.4% if called. Even boring stocks can be ok CC plays BUT at the risk of lower total return. Again, I am also using the income to grow a core portfolio so I am not really losing out that much with a boring stock as the income is put towards capital growth core holdings.

Probably overly verbose and filled with grammar issues but I think you get the idea of my approach of skimming nickels. Harder to do in a smaller account as commissions are a larger portion of the income generated but in larger accounts skimming nickels that are 0.3% premiums can actually mean $1,000 or more per month to reinvest elsewhere, spend on fun, or debt reduction, etc.

[NilesMike]

With 5 contract transactions, I assume you are paying a per contract commission and not one based on size. What is the assignment/exercise fee on the ones that are called away, if I may ask?

If it works for you, I'm not one to quibble. just too much work for too little gain for me while generating too large of a percentage going toward trading fees.

[hendi_alex]

Fees are negligible at TDA. Mine are $7.99 per transaction.