Investors seeking greater yield when the market is trading sideways should consider selling covered calls to generate more income.
A covered call is when an investor owns the underlying shares in a stock and decides to sell calls against his position, said Ron McCoy, a portfolio manager at Covestor, the online investing company, and CEO of Freedom Capital Advisors in Winter Garden, Fla. The seller of the call option is agreeing to sell at a certain price known as the strike price and giving the purchaser of the call the right to buy his shares at the strike price at anytime up until the option expires. Each option contract typically represents 100 shares.
"With the market struggling to make new highs amid the back drop of lower corporate earnings as this is the sixth quarter year-over-year of S&P 500 earnings declines, selling covered calls might be an option," he said. "Many investors have a hard time grasping the concept and in fact many advisors don't employ this strategy, because they struggle to understand the mechanics of how it works."
Investors could sell an out of the money call option on dividend stocks to boost their returns, McCoy said. A retail investor who owns a covered call of AT&T is aware the company will pay a $0.48 every three months, which means between now and April, there is a payout three times of $0.48 each time, which is a total of $1.44.
The April $42 call option is trading for $0.84. If it is not called away by expiration in April, an investor would increase his income on AT&T by 57% during that time frame by selling a call against his shares, he said.
"If it is done properly, covered calls can add another level of diversification in an otherwise boring market," McCoy said.
Investors should not forget about the tax implications of "getting called away as it would generate a capital gain and they should decide if they are willing to part ways with their stock at the strike price," he said.
The trade by a retail investor should be avoided if AT&T was sold at $42 and then rose to $45, McCoy said.
"If you are going to be regretful, then you should not do the trade," he said. "Nothing says you have to cover the whole position. If someone owned 1,000 shares, he could sell two or three calls and leave 700 or 800 shares uncovered."
This "seemingly profitable strategy" for an investor of a dividend paying stock could generate more income from selling a call option, said K.C. Ma, a CFA and director of the Roland George investments program at Stetson University in Deland, Fla. This investment thesis is only successful if the bearish outlook proves to be true.
"All call writers have an outlook that the stock prices will not go over the 'breakeven price' before expirations," he said.
An investor whose goal is to sell a $0.84 April $42 call should be aware that if the stock price goes over $42, the call will be exercised to creep into the seller's $0.84 premium, Ma said. The seller has to deliver a stock at $42.
When the stock's price rises over the breakeven level at $42.84, the seller starts losing dollar for dollar, he said.
"However, the 'wrinkle' favoring the seller of this call strategy is that they are counting on that the call will least likely be exercised, since stock prices will automatically drop on the next three quarterly ex-dividend dates, making stock prices rising over the $42.84 less likely," Ma said.
In practice, stock prices will only decline 60% to 70% of the dividend amount on the ex-dividend dates, he said.
The real risk of this trade for an investor is that the ex-dividend prices should "theoretically drop, but seldom do for the full amount of the dividend since the holder of the stock will also receive the cash dividend," Ma said.
If the ex-dividend stock price drops $0.10 shy of the dividend amount, this will lower the seller's breakeven price from $42.84 to $42.74.
"Before making the trades, the right question to as, for both sides, is, 'What is the chance that AT&T's stock will go over $42.36 by October, $42.72 by January and $43.08 by April?"