Covered Calls To Boost Yield? Watch Out
Introduction
There’s a lot of misinformation on the Internet these days, so one of the purposes of this blog is to provide unbiased and accurate information to my readers, and continually reinforce the idea that each individual investor is different and therefore has different investment needs. My latest pet peeve are the numerous articles I’ve come across which seemingly hint at “tricks” regular investors can do to boost their investment returns. Specifically, how one can use options to boost their income with little to no extra risk.
Listen, here’s the thing. If you can't spot the sucker in the first half hour at the table then you are the sucker.
That quote is from Matt Damon’s character in the movie Rounders, talking about what it’s like to sit at the table with professional poker players. When it comes to investing, I would say this. If you really believe there are tricks to earn extra income with no risk - that there are free lunches - then you are the one being tricked.
Allow me to explain the basics of how options work and how they are riskier than you may have been led to believe.
The Covered Call Strategy
The covered call strategy works by purchasing the underlying shares of a company and simultaneously writing (i.e. selling) a call option for the same number of shares you own. Call options give the holder the right but not the obligation to buy shares at a specific price, known as the strike price or the exercise price. In order to earn this right, call option holders will pay a premium to the seller, usually a small fraction of the share price. As writers of the call option, if the holder decides to exercise his/her option, you have the obligation to sell your shares at the exercise price. A few other features of options include:
In Canada, all options are considered American options, which are quite different than European options. American options can be exercised at any point in time on or before the exercise date, while European options may only be exercised at the exercise date. This is important!
Options are sold in 100 share lots, so multiply all your calculations by 100. If you want to buy the underlying shares of a stock trading at $50, you better come up with $5,000 for this strategy to work.
The Proposal
The proposal usually goes something like this: find a company which is paying a dividend soon, purchase those shares and simultaneously write a call option. You’ll be guaranteed a profit because you’ll be receiving the dividend and the call option premium. If the share price rises and the call option holder exercises the option, you’ll make money off the capital gain, the option premium and the dividend. If the share price drops and the holder does not exercise the option, you’ll still make money off the dividend and premium.
Sound good? Not so fast. A few points investors should consider:
The dividend is not guaranteed. Since we are dealing with American options here, the holder could very well exercise the option before the ex-dividend date and you’ll be stuck with a capital gain or loss and the option premium.
Your losses are virtually unlimited. If the share price falls by say $20, and you’ve earned an option premium of $1 per share, you’ve just lost $19 per share.
These “trick” plans usually imply that you are guaranteed both the dividend and the option premium when that’s simply not true. Your losses are virtually unlimited, especially if you pick a highly volatile stock, and your gains are capped. Let’s look at an example.
Example: Empire Company
From the Montreal Exchange, below are the January 17 options current trading for Empire Company:
The shares are currently trading at $30.60 and Empire will be paying out a dividend of $0.12 per share to all holders on record January 15, 2020. The ex-dividend date is therefore January 14,2020, so if you haven’t sold your shares on January 13, 2020, you’ll be entitled to the dividend. So let’s buy 100 shares of Empire now for a total investment of $3,060.
Next, let’s write a call option with an exercise date of January 17, 2020. Let’s choose the $30 one, where the last premium traded was $0.70. Since they are in lots of 100 shares, this means you’ll earn $70. Now we can run through some example scenarios:
The share price skyrockets to $34 per share on or before January 13 and the holder wants to exercise the option (i.e. they want to buy just for $30). You do get your $70 no matter what. Unfortunately though, you won’t get your dividend since it’s still January 13 and you’ve just taken a $0.60/share capital loss on the transaction (or $60). Net result: gain of $10 on $3,060 investment = 0.33%. If they exercised after January 13 though, you would add $12 to make $22 in total, or 0.72%.
The share price more or less doesn’t do anything and the call option is not exercised. On January 17, the price remains the same at $30.60. You’ve earned no capital gain, but you did earn the $12 in dividends and the $70 in premiums to total $82. Net return = 2.68%
The share price drops to $28 per share and the holder doesn’t exercise the option because they could simply buy shares in the open market for cheaper. You’ve earned your $70 in premiums as well as the $12 in dividends, but you’ve lost $2.60/share or $260 in capital losses. Net return = -5.82%. The losses would keep going theoretically down to zero plus whatever you earn in premiums and dividend income.
The share price jumps to $32 tomorrow and the option is exercised, and then falls back down to your original purchase price of $30.60 on January 17. You’ve earned your option premium of $70 but missed out on the dividend and earned no capital gain. Net return = 2.29%
Using the examples above, clearly the best case scenario is that the share price doesn’t do much and you end up with a 2.68% gain. This is obviously better than the $0.12 dividend on a $30.60 share price to yield 0.39%, but it comes with risks. If you implement a covered call strategy, make sure that the investment you choose is not very volatile because the option can be exercised at any point in time on or before the contract expires. Even if it ultimately returns to the initial share price of $30.60, if it briefly traded above this then the option could be exercised and your gains are limited.
You should also know that on the ex-dividend date, the exchange drops the share price by the amount of the dividend, so whatever you gain in dividend income you will technically lose in share price value. Taking that into account in the example above, you’re basically looking to squeeze an extra $70 in option income by sacrificing future gains and hoping the share price doesn’t crash.
Summary
Investors using the covered call strategy should do so to collect extra income if they do not believe the share price will move much. This would be a legitimate way to beef up your dividend income if your holding period is through the stock’s ex-dividend date and it’s a regular part of your portfolio. But there are risks involved. Your potential gains will be limited, and your potential losses will be virtually unlimited. And if you’re thinking of doing this every month or quarter with the same stock, consider the odds that at least one of those times it will end badly for you.
Keep in mind the following if implementing a covered call strategy:
The holders of call options can exercise their price at any time on or before the contract end date. It makes sense for them to do so if the share price has risen above the exercise price enough to cancel out the premium they paid for the option. But they can still cut their losses on the day of the contract end date, leaving you with a capital loss or less of a capital gain.
Your best case scenario is for the share price to remain in a tight trading range throughout the holding period. If this happens the option may never be exercised and you can walk away with your dividend income and the option premium. Your gains will be limited to these two types of income.
Your worst case scenario is if the share price plummets and the option is never exercised. Sure, you’ll receive your dividend and option income, but you’ll take a much heftier loss on your underlying investment.
Take time to understand a stock’s trading history, volatility, and any events which could drive the share price (i.e. earnings reports). You may unknowingly be betting on the odds of a good quarterly report.
Calculate your projected after-tax return rather than gross return. Option income is taxed at your marginal tax rate and is therefore less favourable than capital gains and dividend income. Covered call strategies are allowed in a TFSA though, but your contribution room may get eaten up quickly if you don’t already have 100 of the underlying shares in your portfolio.
Know that option trading is a zero sum game. Whatever you win, someone else loses. To believe that there is such an easy strategy out there that can earn you extra money, you would also have to believe there are people out there so anxious to throw money away that they are willing to ignore something so obvious to you.
There is something for the rest of us though. Rather than trying to add a percentage point or two to your dividend yield, what can investors do to reduce their risk? I would suggest checking out protective puts, which are on my website under the Options section. A protective put strategy is a way to lock in gains when you’d prefer holding an investment after a big run up, but are worried about a price correction in the near future. Think of them as a kind of insurance, which we all may end up needing a bit more of in 2020.
Good luck!