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Covered Calls for 2014: Keep the Income Coming

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During 2012 and the first half 2013, stocks that delivered dividends were the toast of the town for equity markets as they provided proxies for bonds in the yield-starved world of a zero-interest-rate environment. Real Estate Investment Trusts (REITs), Master Limited Partnerships (MLPs), utilities like Con Edison (NYSE:ED), and even some basic consumer staples like Campbell Soup (NYSE:CPB) all enjoyed high, double-digit gains thanks to their high dividend yield. They were among the best performing sectors within an already broad bull market.

But sometime over the summer, someone mentioned the word "taper," and these stocks tumbled. Hard. Even as the broader market measured by the S&P 500 Index (INDEXSP:.INX) rebounded after the June 19 hiccup, the aforementioned names continued to decline despite the Fed's walk back from its taper talk.

The Tale of the Taper:

Index S&P 500 Real Estate (IYR) MLPs (AMLP) Utilities (XLU)
Performance 1/2012-6/2013 27% 26% 13% 16%
6/2013-12/16/2013 6.5% -(18%) -(5.8%) -(1.55%)

It's clear that even as the Fed took the prospect of taper off the front burner, it's inevitability weighed heavily on bond-proxy dividend yielders.

Keep That Income Coming

While the capital gains portion of these equities may be limited, they still offer a steady income with yields in the 3-to-7% range, well above even a 10-year Treasury note, which should supply a floor in share price. And one way to further boost that income is through the utilization of a covered call strategy. This involves selling an out-of-the-money calls against a long stock position. You can collect not only the stock's dividend but also the premium of the call option sold.

But before proceeding with my endorsement of covered call strategy here are some caveats:

  • It's still risky. Covered calls, or buy-writes, are often promoted as a safe, conservative strategy. It actually has the same risk profile of selling naked puts. If you think naked put selling is crazy, then don't sell a covered call. Yes, the risk is slightly lower than owning the stock outright but so is the reward. But this way of applying them to dividend payers makes sense. More on this later.

  • Covered calls are often peddled by brokers as a safe way to earn income and reduce risk, which is true to an extent. However, claiming that one only need to sell calls and roll them every 30 days to produce 25%-35% annual returns "even if the stock stays still" is misleading. Stocks rarely stand still for extended periods. Selling calls collect 2%-4% a month in option premium is rarely a repeatable event. More likely at some point, the stock will move above the strike price or below the effective purchase price, and you will be forced to make a decision. This forces a decision. Do you roll up or down or just close? The point is that this can be a more labor and costly strategy than it appears on the surface.

  • Covered calls offer little downside protection. The call premium collected reduces your effective purchase price and therefore acts as either downside protection or a type of hedge, but the amount of premium collected is usually a fraction of the price of the underlying shares. In other words, the risk of a covered call is only marginally lower than owning the stock outright. Again, it is similar to selling a naked put.

To sum this up, I think that the biggest mistake people make in using covered calls is applying them to high-beta stocks whose options carry high implied volatilities and therefore extrapolate a high annualized return using the strategy. You will be capping the upside if the stock catches fire or if you have little protection from a sell-off.

The best candidates for covered calls are steady, boring stocks that already offer a decent dividend. These are the tortoises, and as such, sell calls that have 4-to-6 months remaining until their expiration and that are 10% out-of-the-money. This will provide a nice balance of boosting yield, maybe 3-to-5% annualized, and minimizing the need to make monthly, and possibly costly, adjustments.

Just sticking with ETFs, the Real Estate iShares Dow Jones US Real Estate (NYSEARCA:IYR), for example, is trading at $62.50 and offers a 4.2% dividend. One could sell the June $68 call, 11.5% out of the money, for $0.80, which produces an additional 1.3% yield over the next six months.

Utilites SPDR (NYSEARCA:XLU) is trading at $37.50 per share and offers a 3.85% annual dividend. Its June $41 calls, 9.5% out-of-the-money, can be sold for $0.30, a contract garnering an additional 1% over the six-month period.

These numbers might not be huge or sexy, but achieving 6%-plus annual yield with the potential for 10% capital appreciation is very attractive on a risk-adjusted basis, especially in a world of ZIRP.
POSITION:  No positions in stocks mentioned.