“Double Your Dividends!”
That’s the pitch I’ve been seeing in my inbox lately from a fellow investing advisor trying to sell a webinar on covered calls. But what are covered calls, and how can they increase your income from stocks you already own?
Here’s the primer I wrote on covered calls last month, with a new covered call idea at the end:
What Are Call Options?
A call option has two parties: one investor who sells, or “writes” the call option, and one investor who buys it.
The writer agrees to sell a stock at a specified price, the strike price, in the future. If he already owns the stock, it’s a covered call. (If he doesn’t, it’s a naked call, which is much riskier and which we won’t discuss here.)
The other party in the transaction is the buyer. She is buying the right (although not the obligation) to purchase the stock at the strike price in the future.
Let’s look at an example, using a covered call on Procter & Gamble (PG):
Let’s say Paul owns 100 shares of Procter & Gamble (PG), and he thinks the stock is going to stay around its current price of $80 per share for the next month or so.
Paul decides to try and make a little more income from his PG stock by writing covered calls on it. He doesn’t want to be forced to sell his stock on a little blip up, so he decides to write calls with a strike price of $85—a level he doesn’t think the stock will reach. But he wants to get a decent amount of income from the strategy, so he writes calls that don’t expire for 30 days.
The current bid price for a call option with those parameters is 20 cents:
That’s what someone will pay, per share, for the right to buy (or “call away”) Paul’s shares of PG at $85 anytime in the next 30 days.
Paul decides to write the calls on his 100 PG shares. He sells the call options, and in exchange he gets a “premium” of $20 ($0.20 x 100 shares).
Now he waits.
If PG trades above $85 in the next 30 days, whoever bought Paul’s calls will probably exercise the option and buy the shares from Paul for $85 a piece—lower than the market price. Paul will still get to keep the $20 premium, and will get $8,500 for his shares, but it won’t be as much as he could have sold them for in the open market. And he won’t own PG or get its nice dividend stream any more.
But if PG stays below $85, Paul gets to keep the $20 premium income, and his shares.
Income vs. Risk of Writing Call Options
There are a few important things to keep in mind when writing call options.
The premium you get for writing call options is determined by three things: the strike price you choose, the expiration date of the option, and the volatility of the stock.
In general, the more willing you are to risk having your stock called away, the more money you can make. For example, Paul in our example above could get a premium of 50 cents per share if he was willing to write options that expire in 93 days instead of 30:
He could also increase his premium income by choosing a strike price closer to PG’s current price. You can see above that three-month calls with a strike price of $82.50 recently sold for $1.04 per share: that would generate $104 in premium income for Paul.
But, there’s a pretty good chance PG will trade above 82.50 sometime in the next three months and his shares will get called away.
Before writing call options for income, you have to ask if the risk you’re willing to take is worth the money you’re going to make. How reluctant are you to part with your stock?
And if you’re totally unwilling to sell your stock, you probably shouldn’t write call options on it—you never know what can happen.
The Best Stocks for Covered Calls
The Best Stocks for Covered Calls
So you’ve decided covered calls are for you. Now, what kind of stocks work well with a covered call strategy?
Here’s what Marvin Appel, Co-Editor of Systems & Forecasts, which makes many covered call recommendations, wrote in a recent issue:
“In general, I select stocks for covered call writing with attractive levels of premium relative to the S&P 500 SPDR (which is a very low bar these days), whose charts are sideways or in gradual uptrends (avoiding near-term overbought stocks) and with substantial earnings or positive cash flow.”
I looked at the latest Investment Digest for a stock that meets Appel’s criteria, and I think one good candidate is Archer Daniels Midland (ADM). The stock pays a regular dividend of 19 cents per quarter, but if you write covered calls a few dollars above the current price, you can earn a few extra cents per share (currently about 30 cents for calls with a strike price of $35 that expire in 30 days).
As for the stock’s prospects on its own, here’s what Agri-Food Value View Editor Ned Schmidt wrote in the latest Investment Digest:
“Archer Daniels Midland (ADM)—Two factors might have held the stock below potential. One has been the historic importance of ethanol to the company. As U.S. ethanol production is now essentially capped, that issue will fade over time. ...
“Last year, U.S. sales were slightly more than 54% of the company. With the acquisition of GrainCorp of Australia, that will fall to less than 50%. That acquisition allows ADM to become a major player in the Australian grain markets, which have a trading advantage with China and the rest of the Asian region. GrainCorp moves 75% of Eastern Australia’s grain production and 90% of bulk grain exports. ... ADM is undervalued, and well positioned to continue improving. ADM should be in portfolios.”
Wishing you success in your investing and beyond,
Chloe Lutts
Editor or Investment of the Week
Editor’s Note: This article was originally published on 4/19/13.
