Traits of a Great Stock for Covered Call Writing

Thanks to Robert Erich at MoneyNomad for also posting this article; http://moneynomad.com/traits-of-a-great-stock-for-covered-call-writing/ via @rlerich

Covered-call writing is considered the most conservative strategy in option writing.

While it remains unknown to most investors, it is in fact safer than outright stock ownership because the investor’s downside risk is offset by premium income received for selling the call provision. Covered-call writing can either be accomplished by the sale of a call option against a stock you currently hold or through the simultaneous purchase of a stock and the sale of a call option.  One call option is sold for every one hundred shares of stock held. As a call writer, you will receive cash for selling a call, but you will be compelled to sell the stock at the strike price of the call if the stock is assigned out of your account. In effect, an investor with a covered-call strategy is compensated with a premium for agreeing to sell his or her holdings at the strike price. In exchange for being paid this premium, the investor relinquishes any increase in the stock’s price above the set strike price to the call owner.

A call option also has an expiration date, which is the date on which the option expires and becomes worthless. The call owner has the right to exercise the contract and thus call away, or buy, the call writer’s shares. Thus, call buyers assume broad risk.  According to the Options Clearing Corporation’s latest (2014) results, less than 20 percent of all option contracts that were opened ended up being exercised. Thus, a call buyer is practicing a highly speculative strategy. On the other hand, a covered call seller takes much less risk. The first rule of covered-call writing is this: Pick a company that you already own whose current stock price, you believe, is above your target price. Two traits that are critical in selecting firms to write covered calls against are price/earnings ratio and dividend yield.

First, select a company whose dividend yield has fallen below its historical averages. Second, examine the firm’s price/earnings ratio. We’ll review Pepsi as an example. Consider an investor who already owns one hundred Pepsi (symbol PEP) shares, which were purchased in September 2011 at a price of $65 per share. At that time Pepsi was trading at a forward price/earnings ratio of 15 and yielded nearly 4% in annual dividends.  Today, Pepsi trades at $105 share.  Its forward price/earnings ratio is now at 21 and it yields under 3%.  Pepsi has historically traded at a price/earnings ratio range of 13 to 24 in the past ten years.  The firm’s dividend yield has ranged from 2.5% to over 4%.  Pepsi is clearly trading at a historical premium versus its own trading pattern.

Now, an investor may not want to sell Pepsi stock at the time given its solid performance and dividend yield. Capital gains may also be an issue. But an investor may consider selling calls against the position. The first step is to choose the best strike price.  I recommend a price higher than the current price that you are willing to sell at.  Pepsi has call options at $100, $105, $110, $115.   The $110 strike price looks reasonable and is above the current trading price.  Second, select a date at least two months out from today.  Pepsi has calls in October and January.  The January calls offer a much higher price and potential income.

To assist you in the decision making process, you may annualize the returns of the call options for the sake of comparison.  An investor can calculate a yield by dividing the option premium by the current stock price. Then, divide the yield by the number of months in the holding period and multiply by 12 (the number of months in a year). The total is the calculated yield that would be earned if the position were kept open for a full year.  For Pepsi, the January 20, 2017 calls look attractive (strike price $110) and are trading at $1.56.  This means for every 100 shares you own that you sell a call against, you would collect $1.56 per share, or $156.00.  You may choose other calls options that may be preferable from an income standpoint or lower/higher price that you are willing to sell.

For the annualized yield in this Pepsi example take the premium dividend by the price ($1.56/$105) then divide by the number of months on the contract (4.2). This equals .0035, which you then multiply by 12 and get 4.2%   If you want other strike prices for Pepsi or want to write a call on a different stock, you may compare annualized yields to assist you in choosing the right one.  Remember, there are always a multitude of factors that ultimately determine annualized yield.  These include daily movement in a stock’s price (beta), changes in markets, dividend payments, and timing between entry date and expiration of an option.

Covered writing does invite some risk. For example, if Pepsi’s stock price fell to $90, the loss on the stock position ($105 – $90.00 = $15) would surpass the sum of the dividends and call sale proceeds ($0.61 + $1.56).  It would have been much better for an investor to actually sell Pepsi at that point in time.  Alternatively, the price of the stock could well exceed $110.  In this case the investor might lament the writing of the call.  But in most instances an investor will come out ahead when writing covered calls against stocks that are already trading at higher than normal valuations.

This is especially the case in today’s environment as the Dow Jones Industrial Average is up substantially from the lows set in March 2009;

Final Guidelines for Writing Covered Calls 

• Be willing to accept exercise when it happens. When you sell a covered call, you are granting someone the right to call away your stock from your account. You need to be prepared to sell your one hundred shares for the strike price at any point in time after you write the covered call.
• Pick a strike price slightly higher than the price you paid for the stock and at a point where the historical yield for the stock is at its lowest point and price/earnings ratio at an elevated reading.  I never recommend writing covered calls with strikes at or below the current price—they are much more likely to get exercised.
• Most critically, include dividend income when making your comparison. When you are comparing potential income from covered calls, always remember that dividends do play a role in the overall return. If the fundamentals are approximately equal on two or more stocks you are considering writing covered calls against, opt for the company with a lower dividend yield or the company with a dividend payment farther in the future.