Selling call options on stocks owned in a portfolio – a tactic known as “covered call writing” – is a common strategy that can be effectively used to boost returns on a portfolio.

Writing covered calls on stocks that pay above-average dividends is a subset of this strategy. When a stock goes ex-dividend, the market price of the shares will typically fall in step with the amount of dividends per share paid to stockholders. This means that there could be opportunities for short-term profits if the dividend is paid to the shareholder, whose call options then become less valuable do to the drop in stock price. The strategy seems sound, but markets tend to be efficient, and this possibility is often already priced into the option's price ahead of time.

We will illustrate this concept below with the help of an example.

Key Takeaways

  • Covered call writing involves selling upside call options on a long stock position already held.
  • The covered call strategy can boost returns during flat or down markets, but limits upside potential in a bull run.
  • Writing covered calls on dividend stocks is a popular strategy since the shareholder will receive the dividend and may benefit from a drop in share price on the ex-dividend date.

Writing Covered Calls: Example

Consider a covered call written on the stock of telecom giant Verizon Communications, Inc. (VZ), which closed at $50.03 on April 24, 2015.

Verizon pays a quarterly dividend of $0.55, for an indicated dividend yield of 4.4%.

The Table below shows the option premiums (prices) for a marginally in-the-money call ($50 strike price) and two out-of-the-money calls ($52.50 and $55 strikes), expiring in June, July, and August of the year.

Call Option Pricing for Verizon
 

Option Expiration

 

Strike price $50.00

 

Strike price $52.50

 

Strike Price $55.00

 

June 19, 2015

 

$1.02 / $1.07

 

$0.21 / $0.24

 

$0.03 / $0.05

 

July 17, 2015

 

$1.21 / $1.25

 

$0.34 / $0.37

 

$0.07 / $0.11

 

August 21, 2015

 

$1.43 / $1.48

 

$0.52 / $0.56

 

$0.16 / $0.19

Call Option Pricing for Verizon

Note that for the same strike price, options premiums increase the further out in time you go for the expiration date. For call options of the same expiration, their values decrease as the strike price increases, since a call gives the holder the right to buy the shares at ever higher prices than the current market price.

Determining the appropriate covered call to write is thus a trade-off between the expiration and strike price.

In this case, we will decide to use the $52.50 strike call, since the $50 call is already slightly in-the-money (which increases the likelihood that the option will be exercised and stock may be called before expiration), while the premiums on the $55 calls are too low to warrant our interest. Since we are writing calls, the bid price must be considered as that is where market participants are willing to buy from you.

To understand the potential return boost from selling these options, we can compute the annualized implicit yield using the following formula:

Annualized premium (%) = (option premium x 52 weeks x 100) / (stock price x weeks left for expiration)

Writing the June $52.50 calls will thus provide a premium of $0.21 (or approximately 2.7% annualized yield), while the July calls fetch a premium of $0.34 (2.9% annualized) and the August calls have a premium of $0.52 (3.2% annualized).

Each call option contract represents 100 shares of the underlying stock. Assume you buy 100 shares of Verizon at the current price of $50.03, and write the August $52.50 calls on these shares. What would be your return if the stock rises above $52.50 just before the calls expire and is called? You would receive the $52.50 price for the stock if it is called, and would also have received one dividend payment of $0.55 on August 1. Note that $2.47 is the difference between the price received when the stock is called, and the initial purchase price of $50.03.

Your total return is, therefore:

($0.55 dividend received + $0.52 call premium received + $2.47 *) / $50.03 = 7.1% in 17 weeks.
This equates to an annualized return of 21.6%.

If the stock does not trade above the strike price of $52.50 by August 21st, the calls will expire unexercised and you will retain the entire premium of $52 (i.e. $0.52 x 100 shares) less any commissions paid.

Now, what if the ex-date for VZ shareholders is on August 20thth? You would receive $0.55 per share owned, and the stock would fall by around that amount, making the calls less valuable. However, call options already tend to be priced lower than put-call parity would suggest because of the anticipated dividend in advance - making any excess profits from the strategy minimal if at all existent.

Pros and Cons

Opinion seems to be divided on the wisdom of writing calls on stocks with high dividend yields. Some option veterans endorse call writing on dividend stocks based on the view that it makes sense to generate the maximum possible yield from a portfolio at all times. Others contend that the risk of the stock being "called away" is not worth the measly premiums that may be available from writing calls on a stock with a high dividend yield.

Note that blue-chip stocks that pay relatively high dividends are generally clustered in defensive sectors like telecoms, financials, and utilities. High dividends typically dampen stock price volatility, which in turn leads to lower option premiums. In addition, since a stock generally declines by the dividend amount when it goes ex-dividend, this has the effect of lowering call premiums and increasing put premiums. The lower premium received from writing calls on high-dividend stocks is offset by the fact that there is a reduced risk of them being called away (because they are less volatile).

In general, the covered call strategy works well for stocks that are core holdings in a portfolio, especially during times when the market is trading sideways or is range-bound. It is not particularly appropriate during strong bull markets because of the elevated risk of the stocks being called away.

The Bottom Line

Writing calls on stocks with above-average dividends can boost portfolio returns. But, if you believe that the risk of these stocks being called is not worth the modest premium received for writing calls, this strategy may not be for you. Moreover, efficient markets will already price in the dividend in the call option's premium in advance, taking away some of this strategy's attractiveness.