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Covered Calls And Dividends: A Proposed Strategy

Published 04/23/2017, 01:46 AM
Updated 07/09/2023, 06:31 AM

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:

Monthly Cycles

Option Expiration Cycles

  • Every portfolio including covered calls must be looked at daily

(Feel like I just completed a term paper!).

Discussion

Now based on these initial thoughts it would appear that I am skeptical and I am. But let me go back to my original premise that to really know the value of a strategy we must fully educate ourselves and then paper trade. I hope you find my thoughts useful in the educational aspect of evaluating this approach. These ideas should not eliminate this strategy from our consideration but rather strengthen the basis of our analysis.

Market tone

Global stocks edged up for the week as investors focused on positive US corporate earnings and overlooked increasing geopolitical tension and a likely delay in US tax reform. Oil prices declined, with West Texas Intermediate dropping to nearly $50 from last week’s close of $53.25. Volatility, as measured by the Chicago Board Options Exchange Volatility index, dropped to 14.63, down from 16 last week. This week’s reports and international news of importance:

  • In the wake of a failed missile test last weekend, North Korea this week threatened the United States, South Korea and Japan with a “super-mighty preemptive strike” after Secretary of State Rex Tillerson said the US is reviewing ways to compel the North Korean regime to re-engage diplomatically as the US navy is moving an aircraft carrier battle group toward North Korea as US and South Korean forces conduct annual training exercises
  • British prime minister Theresa May called for an early general election in the United Kingdom in an attempt to strengthen her hand in upcoming Brexit negotiations. May’s Conservative Party holds a 20% lead in most opinion polls
  • The pound rallied to a six-month high in the wake of the June 8th election call
  • Treasury Secretary Steven Mnuchin downplayed the odds of Congress being able to pass tax reform ahead of the scheduled August recess
  • The inability of the House Republicans to agree on a plan to repeal and replace Obamacare has delayed potential policy wins on other high priority policy issues, such as improving infrastructure
  • The first round of the French presidential election takes place on Sunday, April 23rd, with four candidates within striking distance of victory. The National Front’s Marine Le Pen and centrist Emmanuel Macron hold slight leads over Republican François Fillon and leftist Jean-Luc Mélenchon. The betting odds favor Le Pen and Macron advancing to the runoff on May 7th, in which Macron, the more establishment candidate, is expected to triumph
  • The US Federal Reserve released its Beige Book in advance of the May Federal Open Market Committee meeting this week. The report noted continued modest economic growth and tight labor markets
  • Despite the Fed’s upbeat outlook for the economy, investors are dialing back expectations of multiple rate hikes in 2017. At present, only one additional hike is fully priced in by markets
  • China’s economic growth rate accelerated to 6.9% in the first quarter, the fastest pace in six quarters. Additionally, retail sales rose 10.9% year over year in March, beating estimates, as did industrial output, which rose 7.6% in March. Analysts had expected fiscal and monetary stimulus to weaken in 2017, but so far that has not been the case.
  • President Recep Tayyip Erdogan last Sunday narrowly won a referendum that expands the powers of the Turkish presidency. Turkey will move from a parliamentary system to a system with an executive presidency. The new system will go into effect at the beginning of the next presidential term. Some observers fear the move is part of a continued drift toward authoritarianism in Turkey

THE WEEK AHEAD

MONDAY, APRIL 24th

· Chicago Fed national activity index

TUESDAY, APRIL 25th

· Case-Shiller home price index Feb.

· Consumer confidence index April

· New home sales March

WEDNESDAY, APRIL 26th

· None scheduled

THURSDAY, APRIL 27th

· Weekly jobless claims 4/22

· Durable goods orders March

· Pending home sales March

FRIDAY, APRIL 28th

· Gross domestic product Q1

· Employment cost index Q1

· Consumer sentiment (final) April

For the week, the S&P 500 moved up by 0.85% for a year-to-date return of 4.91%.

Summary

IBD: Uptrend under pressure

GMI: 4/6- Sell signal since market close of April 17, 2017

BCI: I am currently favoring in-the-money strikes 2-to-1, a defensive posture, no change from last week

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

The 6-month charts point to a neutral to slightly bearish outlook. In the past six months, the S&P 500 was up 10% while the VIX (14.63) also rose by 10%.

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