One of the reasons I like investing in dividend stocks is that I feel that they are inherently less risky than non-dividend paying stocks.  Each time a dividend is received, a small gain on your invested capital is ‘locked in’.  However, in volatile markets, price fluctuations can be significantly greater (in percentage terms) than any dividends received.  To help combat drastic swings in valuation, and to augment the income received from dividends, I’ve adopted a strategy of writing covered calls on suitable long positions.

Writing Covered Calls:
Writing covered call options can be thought of as getting paid for writing a limit sell order.  As with a limit-sell order, a sell price is specified when the options order is entered which limits the maximum achievable capital gain when the contract is in force.  If this sell price is not met when the option expires, you keep the options premium received (free money!) and the stock.  The difficulty in implementing a covered call writing strategy is determining a personally acceptable maximum potential rate of return over the duration of the contract in relation to the options premium received.

Prerequisites:
As each call option represents 100 shares of the underlying security, a covered call writing strategy can only be adopted on long positions involving at least 100 shares.  In addition, your brokerage account must also be approved for options trading.  In Canada, both registered (RRSP, TFSA, etc.) and non-registered investment accounts are eligible for trading covered calls.

Determining an Appropriate Options Series:
Determining what options series to open is highly subjective and is based on a number of factors unique to each investor such as the commission required to write options, the desired annualized yield from options premiums, and the minimum annualized capital appreciation.  To determine the options series that I write for each of my positions, I use the following guidelines:

1.)  Expiry Month
The expiry month of the options series determines how long the options contract will be in force.  As an options’ time value decreases as it approaches expiry, writing contracts with an expiry far in the future will increase the options premium received for each contract.  However, as the time value of options decays more rapidly the closer you are to expiry, the annualized options yield (premiums received per year) can be greater by writing options with expiries in near months (up to three months out).

My rule of thumb for most stocks is that using an expiry date three months into the future tends to provide a balance in terms of capital appreciation potential, options premium received, and trading commissions.

2.)  Strike Price
The strike price of the option series sets the maximum price that you can ‘sell’ the stock for as long as the options contract is in force.  In choosing a strike price, I look at the worst-case total return (capital gains over the life of the contract plus options premium received less commission) of the stock over the two to three month period to expiry.

In general, I tend to write out-of-the-money options with strike prices that allow a total return (not including dividends) of between 7-8% over the length of the options contract.

3.)  Options Premium
As compensation for limiting the potential for capital gains over the length of the options contract, I want to receive at least a 5% annualized options yield (net of commission) on each position I write covered calls on.  Ideally this yield would be higher, but with small positions (writing 1-2 calls at a time) commissions significantly reduce the options yield.

After examining a stock’s call option chain, if I cannot identify an expiry month and strike price that will provide an the annualized options yield greater than 5%, and a worst case total return (less dividends) of greater than 7%, I will not write the contract.  Instead, I will wait until a more volatile market (options pricing increases with market volatility) and then enter into the position.  Otherwise I do not feel adequately compensated over the duration of the options contract for the potential of lower capital gains.

Performance of Options Strategies:
Writing covered calls on open long positions will generally underperform the market in strong uptrends, but outperform the market in downtrends, flat markets, and provide equivalent returns during modest uptrends.  By underperforming during strong uptrends and outperforming in downtrends or flat markets, the overall year-to-year highs and lows in the portfolio will be closer together resulting in lower portfolio volatility.

Over a number of market cycles, the total long-term return of covered call writing should at least equal that of straight buy-and-hold investing.  However, the income generated by a portfolio active in writing covered calls will be significantly greater than that of the buy-and-hold investor.  This can allow for more frequent reinvestment of dividends and options premiums which can help to increase the overall compound growth of a portfolio.

Example:  Microsoft
The following outlines the steps that I would go through in writing a covered call on Microsoft (MSFT) stock.  Note that this analysis is based on a closing price of $25.26 on November 30, 2010.

1.)  Determine a strike price:
Writing a covered call with a strike price of $27.00 would result in a sale price (if called) 6.8% over the day’s close.  A strike price of $28.00 would result in a sale price (if called) of 10.8% over the day’s close.

Based on the above, a strike price of $27.00 would seem to be appropriate as the total return (if called) including the options premium should be between 7-8% over the duration of the contact.

2.)  Determine an expiration month:
In order to receive a decent options premium, February 2011 is chosen as the expiration month.  The options chain for February 2011 calls is as follows for MSFT:

Table 1:  Partial MSFT ‘Call’ Option Chain for Feb/11

As can be seen from Table 1, the bid price for the options with a $27.00 strike price is $0.51.  Thus, for each option written, you would receive $51.  Based on a closing price of $25.26, this is a yield of approximately 2%.  Assuming a $10 options trading commission, the options yield net of commissions would be approximately 1.6%.  Annualized over four quarters, this would result in an options yield (after commissions) of ~6.5%.

Summary:
With an annualized options yield net of commissions of 6.5% and a total return of approximately 8% (plus dividends) over two and a half months (if called), writing covered calls of MSFT for Feb11 with a strike price of $27.00 fulfill my covered call criteria.

Until next time,
Nathan @ EngineeringIncome.com

Disclaimer:
The data and opinions presented above are for educational purposes only and should not be construed as individualized investment advice or as a recommendation to buy or sell the securities in question.  The investing methodology outlined on this site assumes that a stock will perform in the future as it has in the past.  This is generally not true.  It is the responsibility of individuals to perform their own due diligence and/or consult their investment adviser to determine the suitability of any given investment product for their specific situation.  For more information, please see my disclaimer.

Full Disclosure: Author is short MSFT calls and long MSFT stock at the time of this writing.