Covered Calls And Dividends: A Proposed Strategy

 | Apr 23, 2017 01:46AM ET

Covered call writers must factor in dividends into our investment strategies. More specifically, ex-dividend dates for these are the dates shareholders must own the shares to benefit from the dividend distribution. Call buyers must exercise the option prior to the ex-date to capture the forthcoming dividend. This makes our shares subject to early exercise (exercise prior to contract expiration). Relating to this topic, I recently came across an email I received a few years ago with a proposed covered call strategy involving dividends and market timing and thought this would be an interesting strategy to evaluate.

The strategy proposed in this email

This was presented by a well-known timing service and I am wondering if there is any merit to this strategy. Here’s how it works:

  • Portfolio of about $100,000.00 for diversification
  • Each Friday you sell a call option on a stock that pays a dividend of at least $2.00 and yields at least 4% or at least $0.50 per quarter and meet the stock selection criteria. (In our model, it would be passing all the BCI requirements)
  • By selling one security each Friday you will get a decent paycheck weekly
  • The option that needs to be considered along with the dividend is that it should be one strike out of the money (or in the money) depending on the market conditions
  • The strike needs to go out at least three months (to get a decent premium) Example: Sell in March, with an expiration in June etc.
  • Each Friday you repeat this process until 10-13 positions are in place. Then rinse and repeat. I have 13 positions because I believe there are 13 weeks in 3 month periods
  • The service provided have had this model for 2 years and has averaged about $700.00 – $800.00 dollars per week and a profit each year of over 30%. Again, kept for three months to get the extra dividend boost
  • The numbers do not include gains or losses in stock price
  • You only have to look at your portfolio once a week
  • My concern would be the earnings reports and when they come due. I guess you can work around that with so many opportunities out there

Any thoughts on this strategy?

Evaluating a proposed strategy, the Blue Collar way

I believe that a proposed strategy should be evaluated with an open mind. Whether we accept it or reject it, a fair appraisal will be a valuable learning tool. There also may be one or two ideas that we glean that can be integrated into our current strategy. The learning process never ends!

In my view, the best way to determine the value of an investment strategy is to fully educate yourself in all aspects and then paper trade for an appropriate time frame, usually several months. Here are my preliminary thoughts playing devil’s advocate:

  • My initial overall reaction is that this approach takes a relatively simple strategy and complicates it exponentially
  • By requiring our covered call security candidates to have a minimum of a 4% dividend (I’d like to see a max dividend yield as well…too high could mean a decelerating share price) our pool of candidates will be dramatically diminished or our fundamental and technical requirements watered down
  • Holding a stock in a covered call position through a dividend distribution will normally mean holding it through an earnings report as well. This would be a BIG mistake
  • A 4% dividend yield is an annual yield; 1% for the quarter, one third of 1% for the month. Furthermore, when a dividend is distributed the price of the stock oftentimes declines by the dividend amount. Should we be ignoring better-performing securities in favor of a (yawn) 0.3% dividend? If, however, one of those great performers also generates a dividend, even better…we’ll take it. But I would be careful about making my stock selections mainly based on dividend yield
  • No mention of exit strategies which are critical to achieving the highest level of option-selling success
  • No discussion of early assignment of the option. If the time value of the option premium is less than the dividend about to be distributed and if the option Delta is above 0.95 (strike deep in-the-money), there is a good chance that the shares will be sold and no dividend captured. To circumvent, the option could be rolled prior to the ex-date but now our obligation is even greater than three months perhaps on an equity that doesn’t deserve that type of commitment
  • Weekly income seems to be stressed here. Why? When we use the BCI methodology all premiums are collected at the beginning of the contract cycle and can be immediately re-invested at a higher rate than any dividend distribution. By receiving more money quicker, it can be compounded sooner
  • Selling options each week will put us in multiple positions in multiple time frames requiring more intensive monitoring and as I said initially seemingly complicating a rather simple strategy
  • 3-month expirations will generate much lower returns than 1-month options
  • A 30% return is possible with covered call writing but NOT without sophisticated exit strategy management. That much I can say without paper trading. Share price change must be factored into the equation
  • Only one third of optionable securities will have options 3 months out depending on the expiration cycle they have been assigned to:
Get The News You Want
Read market moving news with a personalized feed of stocks you care about.
Get The App