After posting the most recent update of the Ultimate Sustainable Dividend Portfolio last week, I got an interesting question in the comments:
“What do you think about selling covered calls on a dividend portfolio?” – awake
It is a very interesting question, one that I could debate for a very long time. Before getting started, let me just go back to the basics for a minute.
What Is A Covered Call Option?
Let’s start off with a call option. It gives the buyer the right to buy a stock at a given time for a given price. For example, a:
Call AAPL June 600
Would give the buyer the right to buy 100 shares of Apple per option contract at a price of $600. This could be done at any point between now and the 3rd weekend of June. In order to get that possibility, the buyer would pay a price for that option. The seller of such an option would have to sell the shares at that same price but would receive the option proceeds in return.
A Covered Call Option
The only difference between selling a call option and a covered call option is that the seller of a covered call option would actually hold the stock.
How Would A Dividend Investor Sell Covered Calls?
For example, one of the stocks that I own in the USDP is Exxon (XOM), which I’ll use as an example. Currently, XOM pays a quarterly dividend of $0.57. Suppose that I own 1000 shares of XOM, which pay me $5.70 every quarter, how could that be increased? Here are options that are being traded on XOM.
So I could sell 10 options at $0.55 each of the XOM July C 87.50.
If I did this every quarter, I would double the dividend yield. What is the downside to this extra income? The fact that between now and July, if XOM increases quite a bit, I might have to sell it for $87.50. That doesn’t seem too bad does it? Sure, if XOM rises to $95, I’ll be disappointed to sell it for less, but the odds are rather small and even selling it for $87.50 would mean having made a decent profit on the stock right?
Even better, I could do this on all of my stocks, nearly doubling my monthly income and being able to retire even earlier…
Is There A Catch?
Of course there is!! In financial products, nothing comes free. If you get additional income, there is some downside that is associated or something you are giving up. That does NOT mean it is a bad product though. Covered Call ETF’s for example are becoming very popular and they are not necessarily bad products but they do fit a specific type of market and certainly are more tricky to manage.
In the case of selling covered call options in a dividend portfolio, here are the main benefits and downsides in my opinion:
–More Income: Being able to double the monthly income is a huge deal, especially when you are going for a more aggressive dividend portfolio
–Limited upside: The market does usually increase over time and usually not in a straight line. Selling options/upside means that you might have to forefeit big gains in bull markets.
–Transaction & Liquidity Costs: Buying and selling options can end up meaning significant costs both in terms of commissions paid but also the bid-ask spread tends to be higher.
–More Complex: Buying and selling option might seem simple but there are many more variables involved and it becomes a clearly different game. Option pricing requires estimates of volatility, time to expiry, interest rates, etc. If you do not consider those, chances are that you will trade at unfavorable prices. Doing so a few times isn’t an issue but over years it can make a big dfference,
–Time Consuming: Part of the benefit of managing a long term sustainable dividend portfolio is the fact that it requires very little time on a monthly basis. That can change quite a bit if you are selling options, which are assigned on occasion or bought back, etc.
In The End
While covered call strategies do have some appeal, I think that the downside is bigger in my opinion. Of course that depends on each person’s situation. An investor could easily sell longer term options, at higher strikes and reduce the work involved.
What about you? Would you consider selling covered calls on your dividend holdings?here