Combining Dividend Capture With Covered Call Writing: Pros And Cons

When is early exercise most likely?

• Option is trading at parity (all intrinsic value, no time value component)
• Strike is in-the-money (out-of-the-money strikes are unlikely to get exercised because shares would be sold at a higher price than current market value)
• Ex-date is close to the expiration date of the contract

If there is a time value component to the option, the option holder (buyer) is always better off selling the option (thereby capturing both time value + intrinsic value) and then buying the stock prior to the ex-date to also capture the dividend. Exercising that same option will result in the loss of that time value component. Many retail investors are not aware of this and may exercise early even though it is not in their financial best-interest to do so. This is rare but could happen and that exercise notice may end up in our accounts.

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The mathematics of ex-dates

On the ex-date, share value will drop by the amount of the dividend that will distributed at the pay date. If a stock is trading at $20.00 and the dividend will be $0.50, the share value will decline to $19.50 on the ex-date, all other factors remaining the same. This price change has already been factored into the call sale price because call buyers are not willing to pay “full price” for these options knowing about the share decline on the ex-date. For the same reason, put premiums will rise in value prior to ex-dates.

Advantages of the strategy

• Opportunity for 3 income streams from one investment
• Early assignment results in a maximum covered call return (although no dividend capture) and the cash is freed up to generate another covered call profit in the same contract month
• Dividend-bearing stocks are generally higher-quality securities

Disadvantages of the strategy

• We are selecting from a smaller pool (dividend-bearing) of potential covered call writing candidates
• Prioritizing dividends in the screening process, minimizes our fundamental, technical and common sense screens
• Early exercise (also an advantage) may result in loss of shares with potential negative tax issues for low-cost-basis stocks
• Share value declines by the dividend amount on the ex-date so how much additional value are we actually capturing?
• Dividends will add one more factor to consider and monitor
• Dividend-bearing stocks generally offer lower option premiums because they are less volatile than growth stocks

Discussion

A case can be made for both covered call writing and dividend capture in our wealth-building arsenal. The question is whether we should combine the two. In my view, we should not. It is critical to focus like a laser on the strategy we have selected. If it’s covered call writing, then we concentrate on the 3 required skills: stock selection, option selection and position management. Stock selection requires us to screen from fundamental, technical and common sense perspectives. Dividends are secondary and perhaps icing on the cake if a screened stock does generate dividends but is not a priority that may detract from the stated strategy. As an alternative for those who like both income streams why not have two separate accounts? One that is dedicated to covered call writing and the other to dividend capture. This will allow us to maximize our skill sets and target them specifically for each of the declared strategies.

Covered call writing is a cash-generating strategy that lowers our cost basis thereby improving our opportunities for successful investments. One of the many benefits of incorporating this strategy into our investment portfolios is that the system can be crafted to meet our trading style, market assessment, portfolio net worth and personal risk tolerance. This book details three such covered call writing-like strategies that will highlight:

• Option basics
• Practical application
• Calculations
• Real-life examples
• Role of brokerages
• Pros and cons of strategies
• Option Greeks
• Exit strategies
• Flow charts
• Calculator user guides
• And much more

Market tone

This week’s economic news of importance:

• NFIB small-business index May 107.8 (104.8 last)
• Consumer price index May 0.2% (as expected)
• Core CPI May 0.2% (as expected)
• Federal budget -1.47 billion (-88 billion last)
• Producer price index May 0.5% (0.3% expected)
• FOMC announcement 1.75% – 2% (as expected)
• Weekly jobless claims week ending 6/9 218,000 (225,000 expected)
• Retail sales May 0.8% (0.4% expected)
• Business inventories April 0.3% (-0.1% last)
• Industrial production May -0.1% (0.1% expected)
• Consumer sentiment index June 99.3 (98.5 expected)

THE WEEK AHEAD

Mon June 18th

• NAHB home builders’ index June

Tue June 19th

• Housing starts May
• Building permits May

Wed June 20th

• Existing home sales May

Thu June 21st

• Weekly jobless claims through 6/16
• Philly Fed June
• Leading indicators May

Fri June 22nd

• Markit manufacturing PMI June
• Markit services June

For the week, the S&P 500 moved up by 0.01% for a year-to-date return of 3.96%

Summary

IBD: Confirmed uptrend

GMI : 6/6- Buy signal since market close of April 18, 2018

BCI: Favoring 3 out-of-the-money calls for every 2 in-the-money calls.

WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US

The 6-month charts point to a neutral to slightly bullish tone. In the past six months, the S&P 500 was up 4% while the VIX (12.00) moved up by 25%.

Wishing you much success,

Original post

Written By: Dr. Alan Ellman