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Increase Investment Income Using Covered Calls
Many people are looking for ways to increase their investment income in today’s low interest rate environment. One strategy to increase income is to buy high-yield stocks such as AT&T. However, the recent volatility of stock prices has made such direct equity investments too risky for many people. This article explains an alternative strategy combining high-yield stocks with covered calls and LEAPS to allow investors to enjoy investment income that is higher than that of high-yield stocks but with lower risk.
What is a Covered Call?
A call is an option that gives its holder the right (but not the obligation) to buy a specified number of shares of an underlying stock at a given exercise price on or before the expiration date of the option. For example, a call option in AT&T stock (ticker symbol “T”) could give its holder the right to buy 100 shares of AT&T stock at an exercise price of $40 on or before an expiration date of November 16, 2012.
A covered call is a financial transaction where the seller of a call option owns the corresponding number of shares of the underlying stock. For example, the owner of 100 shares of AT&T stock could sell (i.e., “write”) a covered call contract to a buyer who would then have the right to buy 100 shares of AT&T stock at an exercise price of $40 on or before the contract’s expiration date of November 16, 2012.
What is a LEAP?
A Long-Term Equity Anticipation, or LEAP, is an option having an expiration date longer than one year. A LEAP grants an investor the right to buy or sell a specified number of shares of stock at a given exercise price on or before an expiration date longer than one year. The seller of a LEAP is its “writer”, and the buyer is its “holder”. For example, a writer of a LEAP call in AT&T stock could sell the right to buy 100 shares of AT&T stock at an exercise price of $40 on or before an expiration date of January 17, 2014 (which is more than one year from today).
The long-term nature of a LEAP allows long-term investors to bet on long-term trends impacting a stock. By using a LEAP, they can make decisions based on what they think the price of a stock will be more than one year from now, rather than on short-term forecasts which may be impacted by short-term events.
Combining High-Yield Stocks with Covered Calls and LEAPS
High-yield stocks can be combined with covered calls and LEAPS to create an investment strategy that provides higher income than the dividends from the high-yield stocks but with less risk. The steps are:
1. Select a high-yield stock that you would be happy to own outright. For example, if you believe AT&T has a good economic outlook, then select AT&T stock for its high dividend yield of 4.7%.
2. Buy shares of your selected stock in increments of 100 shares. For example, if you selected AT&T as your high-yield stock, then buy 100 shares of “T” in your brokerage account.
3. Select a LEAP call option for your selected stock that you will sell. Option chains can be found at Yahoo!Finance or your broker’s website. For example, to find LEAP call options for AT&T using Yahoo!Finance, type “T” into the “Get Quotes” box, click “Options”, and then click on an options expiration date more than one year away. Clicking “Jan 14” will show AT&T’s LEAP call options expiring on January 17, 2014. Then select one of these LEAP call options, such as the call option with a strike price of $40.00 expiring January 14, 2014. This call option was last sold for $1.34 per share, or $134.00 for a contract covering 100 shares.
4. Sell your selected LEAP call option by selling one contract for every 100 shares of stock. For example, if you bought 100 shares of AT&T stock, and you selected the LEAP call option with a strike price of $40.00 expiring on January 14, 2014, then sell one LEAP contract for $134.00. You can sell this LEAP call option in your brokerage account. If your brokerage account is not authorized for option trades, you will first need to instruct your brokerage to authorize them.
5. Wait until the expiration date of your LEAP. For example, wait until January 14, 2014. At this point, one of two things will happen. If the price of AT&T on this date is above the strike price of $40.00, the LEAP call option will be exercised and your brokerage will sell your 100 shares of AT&T stock for this price. If the price of AT&T on this date is below the strike price of $40.00, the LEAP option will expire without being exercised and you will retain the shares of stock.
Assume you buy 100 shares of AT&T stock for $37.26 per share, and pay a commission of $7.95, for a total of $3733.95. You simultaneously sell a January 2014 LEAP call option contract for $134.00, and pay a commission of $8.70 ($7.95 plus $0.75 per contract), for a total of $125.30. Your net cost for buying the 100 shares and selling the covered LEAP call is $3733.95 - $125.30 = $3608.65.
Since you own the 100 shares of AT&T stock, you are entitled to their dividends. You will receive five quarterly dividend payments of $44.00 each by January 17, 2014, or a total of $220.00 in dividends.
Then, assume AT&T stock is trading at $45.00 per share on January 17, 2014. Since the share price is higher than the strike price, the LEAP will be exercised. Your 100 shares will be sold for $40.00 per share, and you will pay a commission of $7.95, for a total of $3992.05. Your net profits will equal the money you received from selling the shares ($3992.05) plus the money you received from selling the LEAP option ($125.30) plus the dividends you received ($220.00) for a total of $4337.35, minus the money you spent buying the shares ($3733.95). This is a net profit of $603.40, representing a return of 16.7% on the money you invested buying the shares and selling the LEAP, or 12.5% on an annual basis.
Now, assume the price of AT&T stock does not change, and it trades at $37.26 per share on January 17, 2014. Since the share price is lower than the strike price, the LEAP will expire without being exercised. You decide to sell your shares anyway at their market price of $37.26. After paying the $7.95 commission, you will receive $3718.05. Thus, you will have a loss of $15.90 on the sale of the stock, due to the commissions needed to buy and sell it. However, you will have received the $125.30 from selling the LEAP plus $220.00 from the dividends, and so your net profit will equal -$15.90 plus $125.30 plus $220.00, or $329.40. This represents a return of 9.1% on the money you invested buying the shares and selling the LEAP, or a 6.8% return on an annual basis. Note that your 6.8% annual return is 44% higher than the 4.7% return you would have earned from dividends alone!
Now, assume the price of AT&T stock falls to $35.00 by the LEAP’s expiration date. Since the share price is lower than the strike price, the LEAP option will expire without being exercised. You decide to sell the shares anyway on that date at their market price of $35.00. After paying the $7.95 commission, you will receive $3492.05, for a loss of $241.90. However, you received $125.30 from selling the LEAP plus $220 from the dividends, and so your net profit will equal -$241.90 plus $125.30 plus $220.00, or $103.40. Thus, even though the stock price dropped by $2.26 per share, you still made a profit! This illustrates how this strategy helps protect from downside losses if the stock price drops. Of course, if the price of the stock were to drop farther while you own it, you could suffer a net loss rather than a net profit.
This strategy of buying a stock and simultaneously selling LEAPs can also be used with stocks with low or no dividends. The investor will then receive fewer or no dividends, but will still receive a premium for selling the LEAP call option.
Advantages and Disadvantages
The above example illustrates the advantages of this strategy, which include:
1. Higher yields than those from the dividend payments alone; and
2. Downside protection due to selling the LEAP and collecting the dividends.
However, this strategy also has disadvantages, which include:
1. Limited upside potential if the stock price appreciates above the strike price; and
2. Potential net losses if the stock price drops more than the LEAP premium and dividends.
You do not treat the premium received for writing a LEAP call option as income at the time you receive it. Rather, you realize any profits or losses when the option transaction is closed, which occurs when the option is exercised or when it expires. If the option is exercised, you increase the amount realized on sale of the stock by the amount you received for the call. If the option expires, you report the amount you received for the call as a short-term capital gain. For further information on the tax treatment of transactions involving options, see IRS Publication 550 (http://www.irs.gov/pub/irs-pdf/p550.pdf) or consult your tax advisor.
As with other investment strategies, use of the strategy described above carries risks, and you could lose money. Investors should conduct their own research and make their own investment decisions in consultation with their financial advisors.