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Comfort with Covered Calls?
Lets take a favorite stock of mine and my largest holding PM. I currently think that it is under valued. A call a year out with a 10% upside doesn't really pay much. The $95 call at Jan '15 gets you $156 before commission. I don't like getting that small of an amount for selling a call a year out. I really think going up more than 10% has a pretty good chance of occuring. This is why in the new year I will most likely be buying more of PM. To get larger premiums, you need to sell closer to the strike price. Though doing so will cause you to lose out on dividend payments if the price goes up much and the call is exercised early. A year has too much uncertainity for me to sell calls.

The pros are much higher premiums for selling the longer calls. Selling a $95 call for March '14 only gets you $20 where the Jan '15 gets you $156. Also less commissions you have to pay when you sell one call a year instead of one every 3 months.

Selling longer term puts are great as long as you don't mind having your cash locked up long term. Though you will miss out on all the dividend payments. I've never had a put called early. They seem to always want to collect the dividends before giving me the stock.

Selling calls and puts on margin is something totally different. You will need someone that is a lot riskier than me to go over those options. No buying on margin for me. I know that I am possibly missing out on some very large gains, but the downside makes me not want to mess with it.

Hope this helps.
I'm with you ChadR. I'm willing to explore it further, but I'm just not seeing the risk/reward balance being good enough for me to mess with my long-term portfolio. I'm more than happy to use a tiny amount of play money to experiment and have fun with options, but not as part of my dividend growth strategy.
(12-28-2013, 11:53 PM)Kerim Wrote: I'm with you ChadR. I'm willing to explore it further, but I'm just not seeing the risk/reward balance being good enough for me to mess with my long-term portfolio. I'm more than happy to use a tiny amount of play money to experiment and have fun with options, but not as part of my dividend growth strategy.

I think you have made a wise decision.

I would like to share my experience with options. Thanks for posting the question. As background, I am an investor, but I do occasionally trade partial stock positions within my portfolio. I also write covered calls and LEAP's for extra income or insurance.

This example is an actual trade that was made in my portfolio and illustrates an option that expired worthless to the buyer of the option. I sold a LEAP option as described below, collected the premium and did not relinquish the 100 shares of stock. On November 21, 2007 I wrote a single covered call LEAP option on Eli Lilly and Co. (LLY) which, was trading at $50.35/share. I received $301.00 in option premium, and this income reduced my dynamic basis in the stock and went immediately into my core cash. The option had a strike price of $55.00 and an expiration date of January 2009 (a 13 month LEAP option). While I was waiting for the option to either expire or be exercised, I collected the dividend payments for the entire period. In January, 2009 the stock price was trading at less than the strike price of $55.00/share and therefore the option expired worthless to the buyer of the option. I retained the stock and the original premium of $301.00 from selling the option. The net result is that extra $301.00 equates to a 6% boost in annual returns ($301.00/$5,035.00 x 100) = 6%.
There are many variations to trading options, as an example, you can buy them back at a lower price, pocket the gain and keep the stock. You can also stagger the purchase of options within a portfolio, and so on.

Covered Call Options at Initial Purchase:
Using the same information from the previous example, but consider that we are just initiating our first purchase of 100 shares of LLY. We would simultaneously purchase 100 shares and write a 13 month covered call LEAP option. The stock purchase price is $50.35/share but selling the covered call paid a premium of $301.00 ($3.01/share). The net result is that the cost to purchase the stock would be $47.34/share. A 6% discount to the selling price.
Should the price increase above the $55.00 strike price, the option would be called and you would realize a $766.00 profit and the 100 shares of stock would be called away. This equates to an annual gain of 15% before you account for the dividends. When you add the 3.8% annual dividends paid in 2008, you realized nearly a 19% annual gain for your effort. If the option is not called at the expiration date, you hold the stock at a discount to the original purchase price. Writing the option at the time of purchase provides an additional margin of safety.

Covered Call Options as Insurance
Consider a fully functional portfolio and a given stock position that has built a 2/3 partial position of 200 shares and you are not considering selling the stock. The market has been quite favorable of late and we want to protect our gains. We like the gain, but we also like the dividends, we don't want to sell at this moment. But, we would also like some insurance to protect any market downside. If the stock went up to $55/share we would be happy to be a seller. If the stock goes down, we want some protection to preserve our initial gains. Selling a covered call will provide that insurance by putting cash into the core cash account and thereby lowering the cost basis and adding additional downside protection. If the stock goes up to $55/ share your option is called and you have made a good profit. If the option expires worthless to the buyer, you are ahead by the amount of the premium and you still own the stock. Either way you have provided a form of insurance to either lock in a gain or to provide additional downside protection.

Regarding portfolio tracking, I account for all dividend income, trading income and option income and use individual Excel worksheets to track all activity. There is an individual worksheet for each stock and these sheets feed a summary sheet to show total portfolio performance. This method of portfolio tracking is working well for me.

I have managed to systematically build dividend achiever and dividend aristocrat stock positions in my portfolio by reinvesting dividends, trading profit and option profit, then purchasing or selling partial positions based on technical indicators. My goal is to maximize profits from dividends, trading income and option income and at the same time continue to build stock positions. The ultimate goal is a very large and reliable dividend stream produced by holding high quality dividend stocks.


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