Last week Ian Wyatt and I sat down to discuss one of our favorite income strategies, covered calls. The response was overwhelming as we had over 2,000 interested investors attend. But I was bothered by one aspect of our conversation…we were unable to answer all of the questions.
Due to the limitations of the medium in which we presented, we were unable to answer the most popular question of the event: “How do you know which strike price to sell when using covered calls?”
Let’s take you through an example using one of our holdings in the High Yield Trader portfolio.
Currently Microsoft trades for $37.50. So, if we were to sell covered calls for Microsoft expiring in January 2014, which one would we select?
First, I want to say there is no right answer. I know. Lame, right? You want something definitive. Unfortunately, we all have different sets of investment goals so it makes sense that our risk/reward profiles differ as well.
So I’m going to tell you how I select which call to sell in the High Yield Trader portfolio. Remember, we typically choose shareholder-friendly, blue-chip companies that we want to own for the long term. Inherently, the companies we choose are not volatile and they pay healthy dividends. The goal is to double the dividends on each and every holding within the portfolio. Fortunately, we have been able to double, if not triple, most of the dividends in just seven months or less.
There is no doubt that I take a conservative approach in the High Yield Trader portfolio when selling covered calls, and my choice of strikes to sell reflect the conservative native of the income goals of the service.
Again, we want to hold on to stocks like Microsoft as long as possible, collect dividends along the way and sell calls for extra income on top of the dividends. Also, because we are income investors, we are not overly concerned about temporary declines in the stock price. As a result, we choose a strike price significantly higher than the stock’s current price. The reason…the higher you set the strike price, the more likely you will keep your premium AND your stock.
For example, if you look at the table above you will notice the percentages stated in the second column titled, Prob. OTM. This is the probability that your strike or call will close at expiration out-of-the-money (OTM). The higher the percentage, the greater the likelihood your stock will NOT be called away.
But also remember, the higher the strike price, the lower the premium. For example, if you set a strike price of $42, your premium will be $0.15 per share. Since this call expires in less than two months, you can write roughly six of these in a year and rake in $0.90 in premiums. This is an income yield of roughly 2.4% and because the Prob. OTM is 91.28%, you will most likely only be called away less than 10% of the time. Unfortunately, this scenario doesn’t meet our double-the-dividend scenario. Microsoft pays a yield of roughly 3% so we need at least make 6% in additional income through the use of covered calls.
So let’s take a second glance using a different strike price.
If we drop down two strikes to $40, we still have a Prob. OTM of 79.23%. And by giving up just a little in our probability (from 91% to 79%), we are able to bring in almost triple the amount of premium or income by selling calls for $0.42 per share. Just like the previous example, since the $40 call expires in less than two months, you can write roughly six of these in a year and rake in $2.52 in premiums. This is an income yield of roughly 6.7% and it’s the bare minimum that we would be able to bring in. Again, we have made over 14% in income on MSFT in just seven months. Also remember, that this does not include the 3% dividend.
In summary, for our safe, blue-chip dividend stocks, I set a fairly high strike price, which I believe the stock is not likely to push through over the short term. If you are an income investor and do not want to sell your stock, setting a high strike price might be the strategy for you to earn additional income. And it’s exactly what we have been doing successfully over the past seven months in High Yield Trader.
As always, if you have any questions please feel free to email me at email@example.com.