Maximize Your Cash Like the Big Boys

01/26/2012 10:17 am EST

Focus: STOCKS

Andy Crowder

Editor, Wyatt Investment Research

The markets continue to bounce around and for conservative investors it’s hard to find new opportunities to increase their income without having to add to their stock exposure, says Andy Crowder of The Strike Price.

If you’re like most investors, you’re probably looking doubtfully at this stock market.

Is it worth the risk now that many of us are back to where we were before the 2008 crash? Why not just take money off the table, put it in bonds and be done with it?

Well, there’s a little-known way that anyone can keep their stocks and continue to make profits, even if the market takes a further turn for the worst.

The time has come for the average investor, whether wealthy or in the process of accumulating wealth, to consider using a powerful investment strategy—covered calls.

Covered calls are widely used by savvy "institutional investors"—pension funds, insurance companies, endowment funds, and some mutual funds. Yet the strategy is often misunderstood by individual investors.

However, when using highly liquid options on dividend-paying stocks or ETFs, the combined return from potential capital appreciation, dividends, and additional income you receive from covered calls can yield double-digit returns that are more predictable, consistent, and conservative than with dividend-paying stocks or ETFs alone.

As I have often stated in this space, most investors think of options as high-risk, speculative strategies that can result in large losses. While this is certainly true of some option strategies, covered calls are more conservative than investing in stocks or ETFs alone.

More importantly, they can provide significant protection in a down market, and can be a key component for an investor looking to achieve double-digit returns in a flat or slow-growth market.

By now, I’m sure some of you are asking what I mean by the term "covered."

Simply stated, it means that you sell call options on shares of the underlying security—in our case, a dividend-paying stock or ETF—which you already own. The liability of selling those calls means that you are obligated to sell the shares at a pre-determined price (the "strike" price) should the buyer of the calls wish to exercise the option. But your obligation is "covered" because you own the shares.

For example, let’s say that you own 1,000 shares of iShares Dow Jones Select Dividend Index Fund (DVY) and you would like to increase your income on the position with a covered-call options strategy.

While you like DVY’s long-term prospects, you think that the price of your shares may not move more than $5 above its current market price of $54 during the next three months.

It is the third Friday in January (options expiration falls on the third Friday of each month) and you start to check into the premiums for DVY options contracts at various strike prices and expiration dates.

With only 25 days left until February options expiration, the February $59 and $60 calls have no premium available. March offers much of the same in the way of premium. We could sell the March 57 strike call for 10 cents (or $10 per contract) but it would hardly be worth the effort to bring in such a minimal amount.

If we go out to June options expiration—which is 144 days away—the premium looks a bit brighter. But the return is not worth the added time.

The reason for little to no premium in DVY options is due to low implied volatility, a factor in pricing options that captures the underlying stock’s expected volatility throughout the option’s life. Currently, the implied volatility is approximately 13% in February, 16% in March, and 20% in June, well below what is needed to bring in decent premium.

I prefer to see implied volatility of at least 25% to 35% before I begin selling covered calls. So DVY is off my radar as a viable covered-call candidate.

Let’s look at another example of a dividend-paying stock that holds more potential for a covered-call strategy—Diamond Offshore Drilling (DO). Say the stock is around $61.62, where it pays a healthy 6.1% dividend. Let’s assume we own 100 DO shares.

While we could sell covered calls in February and March, I think the best bang for our buck would be to go out to June and sell premium at the 69.25 strike for $1. We would sell one call contract to account for our 100 shares.

For receiving a premium of $1 per share (or $100 per call contract), we are willing to let go of our 100 DO shares should the stock price exceed $69.25 on the expiration date—in our case June 16.

So from this transaction, you will collect $100 in option income. Annualized, the premium income at the current market price of DO will yield roughly 5%. Not too shabby! Add that to the current 6.1% dividend and you have more than 11% of income coming in on an annual basis.

You also have the potential to realize an additional $763 of capital appreciation if the price of DO exceeds $69.25 per share on the expiration date.

Now the downside. If DO would go to, say, $73 before the expiration date, you would lose out on the capital appreciation above $69.25. You would receive only $69.25 per share no matter how high the market price reaches.

Of course, you would retain the option premium of $1, for a total of $70.25 per share. If the stock hit $73 by expiration, you would miss out on receiving the added $2.75 had you done nothing but hold the stock.

But don’t forget, you also have $1 per share of downside protection if DO’s price heads south. In this case, your breakeven point for the position is a stock price of $60.62 (the current price minus the premium received).

It is important to realize that it is still possible to lose money buying DO and using covered calls if the price of DO declines significantly. However, if you are caught in a declining market, you will always be better off using covered calls on your shares compared to just owning them.

That’s because the premium income gives you the added downside protection that you would not otherwise have.

Just remember, using covered calls means you are no longer in the business of trying to maximize capital appreciation on your shares. You are now in the business of using covered calls to provide a rate of return that will meet or exceed your objectives on a consistent and predictable basis.

Subscribe to The Strike Price here…

Related Reading:

Related Articles on STOCKS

Keyword Image
The Best Buys in Cybersecurity
12/08/2017 5:00 am EST

After weeks of sifting through hundreds of cybersecurity stocks on the market, I finally narrowed my...