One strategy that all investors should be aware of, even if they never use it, is writing covered calls. The use of this strategy can significantly boost investment returns, particularly in flat or declining markets, and can also allow an investor to derive income from a non-dividend paying stock. This can be very important for individuals that depend on their investments to meet their income needs, such as retirees. It is this second use for this strategy that this article is primarily concerned with.
What is a covered call?
A call option is a derivative contract that gives the buyer of the option the right, but not the obligation, to purchase a specified number of shares (usually 100) of a specified company at a specified price, called the strike price. The seller of the option has the obligation to sell the specified number of shares to the buyer of the option at the strike price. In exchange for this right, the option buyer pays an upfront fee, known as the premium, to the seller of the option. The buyer of the option is essentially betting that the price of the specified stock will be higher than the strike price before the date that the option becomes invalid, known as the option expiration date.
The option seller is essentially making the opposite bet. Since the seller of the option gets to keep the premium regardless of what happens, the seller will earn a profit if the specified stock does not go higher than the strike price by the date that the option expires.
The seller of an option is also known as the option writer. Therefore, as could be inferred, the covered call writing strategy is based on selling options. But, what about the "covered" part? That is the integral second part of this strategy. This means that the call writer already owns enough shares of the specified stock to meet the demands of the option buyer should the call option be exercised. For example, if the buyer has the right to buy 100 shares of the specified stock from the seller then the seller will already own 100 shares of the stock that could be immediately sold to the buyer should the buyer exercise (use) the option. This substantially reduces risk since the option writer would otherwise have to buy the shares at a possibly substantially higher price than what the buyer is paying in the event of option execution.
How to derive artificial dividends from a non-dividend paying stock
As I already mentioned, the covered call writer is seeking to derive their profits from the premium that the option buyer pays. This option premium can effectively be used to artificially turn a non-dividend paying stock into a dividend-paying one. To get an idea of how this works, please allow me to show how to do it with one of my favorite non-dividend paying stocks, Pacific Drilling (NYSE:PACD).
This chart shows the current prices and volumes for the Pacific Drilling April 2014 options which expire on April 19, 2014:
The price that is most important to option writers is the bid price, as this is the price that market makers are willing to pay for the option. As the chart shows, the bid price on the $12.50 strike price option is $0.10. This option would give the buyer the right to buy shares of Pacific Drilling for $12.50 a piece between today and April 19.
There are a few nuances here that are common to all option contracts that are important to consider. First, each of these options is for 100 shares of stock. Therefore, by selling any of these options, the option writer will need to sell 100 shares of Pacific Drilling to the buyer should the option be exercised. Second, the bid prices given are on a per share basis. Therefore, selling one contract will net the seller $10 ($0.10 x 100) instead of $0.10.
These options expire in three months. Therefore, an investor could conceivably write these contracts four times per year, earning the option premium each time. The payment schedule could thus be roughly equivalent to a quarterly dividend. This is why I say that this strategy could be used to generate a synthetic dividend from a non-dividend paying stock.
Like all investment strategies, the covered call writing strategy does have risks. The greatest of these is the risk that the stock price could rise above the strike price. In the case of our example, if shares of Pacific Drilling trade above $12.50 then the option writer will likely be forced to sell his or her shares of Pacific Drilling at a price of $12.50 regardless of what the actual stock price is. Thus, any upside over $12.50 is sacrificed. However, the option seller would still turn a profit if the purchase price was less than $12.50 per share. In addition, the seller keeps the option premium even if the option is exercised.