Using LEAPS Covered Calls to Increase Dividend Yield

05/17/2013 7:00 am EST

Focus: OPTIONS

Alan Ellman

President, The Blue Collar Investor Corp.

Selling deep in-the-money call options will enhance a stock's dividend yield and provide downside protection, writes Alan Ellman of TheBlueCollarInvestor.com.

Innovative covered call writers can develop ideas of implementing a strategy in unconventional ways. For example, we can invest in a money market or CD and perhaps not even beat the inflation rate with those dividends. We can buy a quality bond and wait six months to receive our first (ho-hum) return. Covered call writers can invest with one-month options and generate returns of 2-4% in normal market conditions but incur some risk in the process (the risk is in the stock, not in the sale of the option). Can we incorporate covered call writing and dividends to generate returns somewhere in between the two strategies? We are Blue Collar Investors, of course we can! Let's buy a stock that we have confidence in and sell an option, which will decrease our cost basis and thereby increase our percent returns.

The Strategy

  • Buy a high-dividend yield stock
  • Sell a long term (LEAPS - more than nine months) deep in-the-money call option to reduce cost basis
  • Increase the dividend yield and create downside protection

Stock Requirements

  • Must be a candidate for a long-term holding
  • Must have options
  • Must have LEAPS
  • Must provide a dividend yield that meets our goals. Many stocks on our premium report will have not have dividends or yields high enough for this strategy. We must therefore use stocks that require less stringent screening procedures. Since we have huge downside protection with deep in-the-money calls our risk is still limited.

Once we have located a stock that has met our requirements, we must look for the dividend and yield information. A good FREE site for this is www.finance.yahoo.com.

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For GSK, the dividend is $2.03 per year and a yield of 5.3% based on current market price of $38.07. Dividend yield information for stocks passing the BCI screens can be accessed from the premium report:

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The column highlighted in green shows dividend yield for a running list in a premium report. As stated above, there will NOT be many stocks from this list that would be great candidates for this strategy.

Once we have decided on an equity, we need to access an options chain and check the premiums for long-term deep in-the-money calls:

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This example was archived from February 2011 and the January 2012 $25 call option is highlighted. We can generate $12.90 per share or $1290 per contract by selling this option.

NEXT PAGE: Advantages & Disadvantages

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Calculations Before Covered Call Writing
$2.03/$38.07 = 5.3%

Calculations After Covered Call Writing
By generating $12.90 per share, we are reducing our cost basis to $25.17. Our new equation is:
$2.03/$25.17 = 8.07% (slightly lower if the option is exercised and we sell for $25. Our plan, however, is to continually roll the option to later expiration dates).

Increase in Returns
8.07% - 5.3% = 2.77%
2.77%/ 5.3% = 52% increase

Advantages of This Strategy

  • Superior yields (+2.77% or 52%)
  • Downside protection (from $38.07 to $25.17)
  • Immediate cash flow + dividends
  • You know maximum profit and breakeven
  • Can implement exit strategies if needed
  • Deep I-T-M strikes have high deltas. If we want to close our position it will be less costly to do so because option value will decline dollar-for-dollar with the stock price decline
  • Less time required to monitor positions

Disadvantages of This Strategy

  • No upside potential if price accelerates
  • You can lose money if the stock drops more than the premium and dividends collected
  • May be taxed at the unqualified rate. Check with your tax advisor
  • Assignment risk because of deep I-T-M calls
  • Must own securities through earnings reports
  • Lower yields than selling one-month options
  • If the time value of the option is less than the dividend, your option may be exercised prior to the ex-dividend date and the shares sold. In this case you will not lose any money but you will not generate any additional income from this position. The cash will then be used to enter a new position. Let's explore the possibility of early assignment in more detail:

Early Exercise of Calls for Dividends
When is it likely that the option holder will exercise the call option (we sold) early to capture a dividend? This is the primary risk with this strategy.

First let's recall the equation for the value of a call option:
Call value = intrinsic value + time value

This can be redefined as follows:
Call value = intrinsic value + interest rate value + volatility value - dividend value

Considerations Just Prior to the Ex-Dividend Date
Let's assume a stock is trading @ $50 and will go ex-dividend by $2 the next day. There is a $40 call about to expire in 10 days. The $40 call has a theoretical value of $10 and a delta of 1. Therefore, the stock and the option have similar characteristics. Here are the three choices as the option holder:

1. Hold the option and take no action: The stock will open $2 lower because of the dividend deduction. The option will open @ $8 since the delta is 1 and this is the new parity price. This approach will guarantee a loss of $2, not really a good choice.

2. Exercise the option: We will buy the stock for $40, then lose $2 when the stock goes ex-dividend but also receive the dividend because of our share ownership. This is clearly better than choice 1 as we break even rather than lose $2. This is why sophisticated option holders will exercise prior to the ex-dividend date.

3. Sell the option and buy the stock: If the option is trading at parity (equal to the intrinsic value) this is the same as choice #2. If the option is trading for more than parity, let's say $10.25, the option holder will generate an additional $0.25 per share making the third choice the best one.

NEXT PAGE: Conditions for Early Exercise

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Conditions for Early Exercise

1. The option must be trading at parity: If the option is trading at more than parity, the holder should sell the option and purchase the stock at market. Most deep-in-the-money calls will be trading at parity near expiration Friday.

2. The option must have a delta close to 1: This will ensure that the option and the stock have the same characteristics so that the holder is not losing out on any time value. In our example, if the call holder feels that there is a chance that the stock value can drop below $40 prior to expiration he would prefer to hold the call as the potential loss would be limited to the call premium. Holding a long underlying (the stock), on the other hand, can result in a much greater potential loss. If there is a delta close to 1, there is almost no market expectation of the stock going through the exercise price. Here is a breakdown of parameters to consider:

A delta of 1 will almost definitely be exercised
A delta above .95 has a high probability of exercise
A delta below .95 is unlikely to be exercised

3. Volatility considerations: Options in low-volatility markets are exercised more frequently than those in high-volatility markets.

4. Time to expiration considerations: With all other factors being equal, the delta will rise as we approach the expiration date. This will increase the chance of early exercise. Those selling deep-in-the-money LEAPS to increase dividend yield may want to roll the call option as the delta approaches .95.

Strategy Objective
Try to sell an option that will bring the cost basis down to as close to the strike price as possible. For example, if a stock trades at $38 and you can sell the $25 call for $13, we have an ideal scenario.

Stocks to Consider (as of May 2013)
Here are a few stocks that have dividend yields between 4%-8% and also trade more than 250,000 shares per day. They also have LEAPS options associated with them:

AZN
CPNO
DUK
VZ

Conclusion
Selling deep in-the-money call options will enhance the dividend yield and provide downside protection. Our risk of early assignment can be mitigated by monitoring the delta of the option and rolling out should the delta reach or exceed .95. Please note that this is not a strategy I use myself but one which I researched and wrote about in response to the interest of many of our members. It is a strategy most appropriate for ultra-conservative investors.

By Alan Ellman of TheBlueCollarInvestor.com

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