Dividends and covered call writing

Asset allocation, risk, diversification and rebalancing. Pros/cons of hiring a financial advisor. Seeking advice on your portfolio?
Post Reply
User avatar
parvus
Veteran Contributor
Veteran Contributor
Posts: 10014
Joined: 20 Feb 2005 16:09
Location: Waiting for the real estate meltdown on Rua Açores.

Dividends and covered call writing

Post by parvus »

I happened across this topic and I'm wondering what I'm missing. I understand that with covered call writing on growth stocks, you're going to miss the upside so I remain in the sceptical camp.

But how does covered call writing affect dividend stocks? Logically, they would get called as their yield drops, wouldn't they? Mr. Market is buying up the stock and reducing the yield. Shouldn't you be glad the stock was called away?
Wovon man nicht sprechen kann, darüber muß man schweigen — a wit
Imagefiniki, the Canadian financial wiki Your go-to guide for financial basics
Image
User avatar
Norbert Schlenker
Veteran Contributor
Veteran Contributor
Posts: 7960
Joined: 16 Feb 2005 09:56
Location: An Argument Surrounded By Water
Contact:

Re: Dividends and covered call writing

Post by Norbert Schlenker »

By writing the option, you're giving up the upside whether the stock pays a dividend or not. Why would you be glad if you're called on the dividend payer?

If the argument is along the lines of, "Well, I want a 4% yield so I bought XYZ, and now XYZ is up and yields only 3.5%, so no problem if it gets called away," then I would pose the following two questions:

1. Why not just use a limit order a little above the strike you're thinking of selling? It's economically equivalent to the call writing.
2. If the goal is to switch to another 4% dividend payer with the proceeds, what will you do if there aren't any around, e.g. if the market generally has moved higher and yields less?
Nothing can protect people who want to buy the Brooklyn Bridge.
mr_l
Contributor
Contributor
Posts: 164
Joined: 23 Dec 2013 00:06

Re: Dividends and covered call writing

Post by mr_l »

Also realise the writer would be collecting a lower premium on a dividend stock then a growth stock. If the option is exercised then the writer loses (sells) his/her shares. Did you want to exit the stock? Are you now done with that company? If not, then you either re-enter at a higher price (now that prices are up since the option exercised) or wait for price to come back down which may not happen and you'll miss dividends also.

Of course, after your covered call option exercises you could write a (cash covered) put option below market price - collecting premiums while you wait for price to dip back so you can regain your stocks in that company.
mr_l
Contributor
Contributor
Posts: 164
Joined: 23 Dec 2013 00:06

Re: Dividends and covered call writing

Post by mr_l »

Norbert Schlenker wrote: 1. Why not just use a limit order a little above the strike you're thinking of selling? It's economically equivalent to the call writing.
I don't follow. If I own 100 shares and stock is at $10, are you saying placing a good-til-cancel limit order to sell 100 shares will bring the same results as writing 1 call contract at a $11 strike? Surely in the latter case I will come out ahead by the value of the option premium, no?

And if your point is to set limit ABOVE the strike you were going to set (where the amount above equals the premium) then this would still be worse than setting the option strike at that limit price, again because with the option you get cash up front whereas without the option you are not getting paid to wait for your limit to trip (apart from dividends)
User avatar
parvus
Veteran Contributor
Veteran Contributor
Posts: 10014
Joined: 20 Feb 2005 16:09
Location: Waiting for the real estate meltdown on Rua Açores.

Re: Dividends and covered call writing

Post by parvus »

Okay, I'll rejig the question.

Assuming you're a dividend investor, and you're writing a covered call, meaning that you'll get called if the stock goes up (which, in the meantime, has reduced your dividend yield), what prevents you from investing in another high-dividend stock and doing it all over again?

I could see writing calls on high-dividend stocks that would appear to be stressed. Pari passu, I'd just wait for the dividend. (But of course I have no guarantee that the stock will continue to pay out such lavish dividends.)

Why wouldn't I, quite passively, let the market knock me out, from a dividend perspective. (This assumes that investors have different reasons for investing: some want income, some want growth. There can be arbitrage that takes no notice of investor intentions, but how comprehensive is that arbitrage? What metrics do the quants use?)

So my basic question is: can this work? It's not something I've devoted a lot of time to, but it seems to me to be an interesting problem.

Norbert and mr_I are generally recasting this in terms of option pricing which, at the Nobel limit, must be efficient in pricing risk, and allow for easy substitution with the cash market, with limit orders and such.

In theory, these are economically equivalent actions. But does that work from an income perspective? Yes, you may not find another 4% dividend payer to replace the one that's just been called away. But what if you write a covered call on the next best thing, a 3.5% dividend payer, and collect premiums while waiting for it to be called?

You may not get the yield that you had before the stock was called away. Then again, you wouldn't have gotten the same yield if you'd held onto it -- though you might be pleased with capital gains that won't exactly, or consistently, fill your cereal bowl.

(These are not things I would do myself; but there are a lot of covered-call ETFs out there and I'm trying to figure out how they work -- or whether.)

What am I missing? Parity theories? Empirical accidents? Publicity porn?
Wovon man nicht sprechen kann, darüber muß man schweigen — a wit
Imagefiniki, the Canadian financial wiki Your go-to guide for financial basics
Image
User avatar
Shakespeare
Veteran Contributor
Veteran Contributor
Posts: 23396
Joined: 15 Feb 2005 23:25
Location: Calgary, AB

Re: Dividends and covered call writing

Post by Shakespeare »

Well, pretty well all of the 2000-ish stuff blew up.

Not sure about the current batch.

Nonetheless, I expect that friction costs and too many hands in the till will limit returns.

More stockbroker's yachts.
Sic transit gloria mundi. Tuesday is usually worse. - Robert A. Heinlein, Starman Jones
User avatar
parvus
Veteran Contributor
Veteran Contributor
Posts: 10014
Joined: 20 Feb 2005 16:09
Location: Waiting for the real estate meltdown on Rua Açores.

Re: Dividends and covered call writing

Post by parvus »

Yes, this is why I approach it skeptically, given the history.
Wovon man nicht sprechen kann, darüber muß man schweigen — a wit
Imagefiniki, the Canadian financial wiki Your go-to guide for financial basics
Image
mr_l
Contributor
Contributor
Posts: 164
Joined: 23 Dec 2013 00:06

Re: Dividends and covered call writing

Post by mr_l »

Think your strategy is fine. Find a quality, high yield stock; buy it; write covered calls (eg every 3 months so time commitment is reasonable) and collect both dividends and premiums until the option executes and your position is sold at a capital gain (bonus: premium taxed as a capital gain). Then do it again with this stock or another, such as one with high yield like you suggest.

Of course, there is no downside capital protection. The price of the stock goes down then you have to choose between staying the course or cutting your losses. You could purchase a put option to limit your downside, but of course the premium you pay will reduce the yield from your dividends and call premiums.

The other downside is more transactions - more broker fees and tax records.

Finally, option pricing is hairy. So stay away from thinly traded options (ie the entire Montreal exchange) unless you are confident in coming up with the right option price.

You could use a practice account and try it out for a year. For those with the time and energy, I think options can tweak risk to be more conservative or aggressive depending on your appetite.

mr_l

PS As far as what you are missing......you haven't acknowledged that (1) you will lose money if stock price goes down, nor (2) yield will be worse than anticipated if dividend is cut. High yield may indicate one of these outcomes is likely. In these cases, you'll still make out better than if you had not written the calls. With a covered call strategy, you do better when the stock price goes down, is flat, or goes up a little (up to the strike price + premium). You do worse when the stock price goes up a lot (beyond the strike price + premium). I consider covered call writing a conservative strategy for these reasons (giving up big upside to improve downside or sideways-side).
User avatar
parvus
Veteran Contributor
Veteran Contributor
Posts: 10014
Joined: 20 Feb 2005 16:09
Location: Waiting for the real estate meltdown on Rua Açores.

Re: Dividends and covered call writing

Post by parvus »

Thanks, mr_I.

It's not a strategy that I would do myself, but there are some ETFs that do seem to do it. I'm trying to figure out the secret sauce -- if there is any.
Wovon man nicht sprechen kann, darüber muß man schweigen — a wit
Imagefiniki, the Canadian financial wiki Your go-to guide for financial basics
Image
mr_l
Contributor
Contributor
Posts: 164
Joined: 23 Dec 2013 00:06

Re: Dividends and covered call writing

Post by mr_l »

All things equal, I would expect to see a covered call ETF to outperform in down, sideways, and slifht bull markets and underperform in raging bull markets. In the raging bull market, I'd still expect a greater yield from the covered call ETF, but less price appreciation. (Of course, if MER is higher than not all things are equal and to be seen if the call premiums can outperform the MER increase)

Disclosure: I am guessing at all of this based on a rudimentary knowledge if options
Post Reply