Covered Calls, Dividends & Passive Income

Would you buy a “risky” stock if you could get a 40% discount off its current share price? That’s what you can get with some of the high-flying stocks listed on Options Buddy.com.

I came across this site while doing some reading online. Many of the stocks listed on Options Buddy are what you would call high risk, but after investigating some of the stocks they do present an interesting value proposition. For example, Options Buddy lists Freddie Mac (FRE). As of August 2^nd the stock was trading at $7.98, so if you wanted you could by 100 shares for $798 (plus commissions). What make this interesting is if you bought the stock you could also sell a Jan 2009 $9.00 call for a premium of $2.00. This would immediately net back to you $200 or 25% of you original purchase price. Not bad!! Who doesn’t want a 25% rebate on anything they buy.

Now it doesn’t protect you from the down side risk, but again it’s important to buy the underlying stock not the premium. There is also the risk that FRE is going to go above $9.00 a share by the expiration date in which case you would miss out on higher returns. Again, I’m looking to hit a solid single or double instead of swinging for the fences. If you were to get called out above $9.00 it would represent a 38% gain in about 6-months; 25% of which you would have receive immediately.

If your longer-term bullish on FRE and you plan on a 12-month or longer investiment time horizon you can sell a Jan 2010 $12.50 LEAP (Long-term Equity AnticiPation Security) for a premium of $2.20. Again this puts approximately 27.5% of your purchase price back in your pocket and if you hold the stock until the option expiration and it’s above $12.50 your total return would be 84% in about 18-months.

In the interest of full disclosure I am not an investment professional and I have not tested any of these trades myself. I am not recommending anyone buy or sell stock in this fashion without consulting a professional. I am merely writing about some of my observations.

Some other stocks that present intriguing opportunities are:

Now most of these stocks are highly speculative at best, but even Jim Cramer says you can have one flyer in your portfolio.

It’s even more interesting if you look at LEAPS out to Jan 2010. For example, you can buy General Motors (GM) today for $10.23 a share and sell a Jan 2010 $20 LEAP and receive $1.90 per share premium. So you are getting approximately a 19% rebate off the cost of the stock. You keep the stock and in order for you to get called out it would take an almost 100% increase in the price of the stock. Again you are not protected from declines in the stock price, but if you believe a stock has been unfairly beaten down it may be worth a try.

I am getting ready to compile my July passive income results. I will hopefully post that later this week.

So as I wrote in my previous post July Covered Calls Part I, I had a not so favorable Covered Call trade with STLD. I learned a lesson and need to keep moving on. Just on a side note STLD posted record profits on July 22^nd and a second quarter net income increase of 124%. It did nothing for the stock. The market has decidedly moved against raw material producers and not much is going to change that in the short-term. Is there a buying opportunity here, probably, but I’ll save that for another post.

Given the overall move in the market against raw materials and specifically oil; on July 8^th I decided to write a Covered Call on UltraShort Oil & Gas ProShares (DUG). I did a “Buy / Write” and sold two July $33 calls. The transaction looked like this:

Well this was much better. I covered my loss on STLD and made an extra $224.

The Call ended up being assigned because the closing price on July 18^th of $34.20 was above the $33 strike price. Yes, I could have made an additional $240 if I would have owned the stock outright, but I’m happy with my return. The return on my investment with the Call premium was 2.5% in 11-days. Annualized it’s over 30%.

I decided to stay with DUG for the August calls. On July 25^th I bought back into DUG at $33.69 and wrote two (2) August $35 calls for a total premium after commission of $358.04.

There is an old saying “Don’t fight the trend“. I think oil is in a downward trend for a while, or at least until the next hurricane comes along (hello Dolly). DUG has been closing solidly above its 50-day EMA and Oil closed below $131 a barrel for several days, which appeared to be a previous support level. At least this is my opinion, but what do I know I still like steel stocks.

I‘ll let you know how my August Covered Call turns out after the August 15^th expiration. I’d be interested in hearing if anyone else out there has been trading or writing Covered Calls on DUG.

One final note, I received a nice comment from a guy on my disastrous STLD call. He has a website called Options for Rookies. I haven’t had time to look at it in too much detail, but it seems like a useful site. I’ll check it out this weekend when I have more time.

Well, my second go-round with covered calls was a scary one. As I mentioned in my June Results post Steel Dynamics (STLD) took a huge tumble. I bough at $40.02, pretty much the top, and from there it dropped like a stone. I am still long term bullish on steel stocks. There has been a sell off lately because of the “global slowdown” and bad news from the auto industry, but long-term I think the future is bright.

On a side note, Goldman Sachs placed steel producer Worthington Industries (WOR) on its Conviction Sell List, sighting a slowdown in the auto industry, etc. I have been investing in WOR since 1998, buying on dips through their Direct Stock Purchase Plan (DSPP) and collecting the dividends. I haven’t had a lot of money to invest in them, but I always invest about $100 on pull backs like this and I have done very well over the years. My cost basis is around $15.

Anyway, I stopped out on STLD, closed my option position and ended up taking about a $226 dollar loss. Actually the loss was about $600, but it was offset by the $438 I receive from writing the first call. The transactions looked like this:

Sigh….my first hard lesson learned:

“Don’t Chase Premiums”

Actually I learned some other lessons as well, but this was the big one.

So despite my loss I still wanted to get in before the July 19 options expiration date so I waited a few days to collect my thoughts. I researched a lot of stocks searching for one with a decent premium, but not as much volatility. I was really gun-shy and couldn’t decide what to do. I remembered seeing a book on writing covered calls on EFTs; it was called Covered Call Writing With Exchange Traded Funds. When I came across this book on Amazon I didn’t think it looked all that great so I didn’t buy it, but it made me think about EFTs as a covered call possibility. This is an area I will definitely explore more; maybe I’ll even go back and get the book. So on July 8^th I decided to write a call on UltraShort Oil & Gas ProShares (DUG). I did a “Buy / Write” and sold two July $33 calls. More on how this covered calls goes in my next post after the July 19 options expiration….

I would like to start off by saying I am a big proponent of dollar cost averaging. Why, because it is a way for individuals to invest a small amount in stocks and EFTs without having to commit a large sum of money for an initial investment. Most individual investors do not have a large sum of money to commit all at once and need to take small steps to build their portfolio.

I used to have a traditional brokerage account, but like most people found it costly to purchase one or two shares of a stock per month. I think this why you see so many individual investors look at stock under $20 so they can get a large number of shares for relatively small investment. I used to be one of these people and to a certain degree still am, but I am trying very hard to stop this. Swinging for the fences on lower priced stock is a risky strategy and at least for me often turned into a losing bet. Remember stocks are generally “cheap” for a reason. Dollar cost averaging either through the company’s DSPP or a broker that specializes in this service opens up to people stocks that they may normally never look at because the per share cost is to high.

What is dollar cost averaging? It is investing a fixed dollar amount typically each month in a single investment (stock or mutual fund) or baskets of investments, with the premise that more shares are purchased when the investment is priced low and few shares when it’s priced high.

I know this method of investing has some detractors and I will try to cover their rationale in a later post, but since I support this type of investing lets start with some of the benefits as I see them.

1. Reduces risk, especially during time of high market volatility
2. Allows small investors to purchase shares in high-quality companies without a big initial investment.
3. Can be less costly than a traditional broker.
4. Fractional shares

What you do get with dollar cost averaging is lower risk and possibly a lower investment cost. In times of high market volatility it can reduce your average per share cost. Here is how I personally use dollar cost averaging to invest.

I still have three Direct Stock Purchase Plans (DSPP) / Dividend Reinvestment Plans (DRIP); they are WOR, J&J and PNY. These plans charge no fees for optional cash purchases, and the PNY offers a 5% discount on reinvested dividends. I still regularly contribute money to them. I have cashed out several plans recently because it just became to unruly to track my investment. Plus I didn’t like the fact that I couldn’t immediately sell a stock if the situation warranted. Enron used to have a DSPP I can only imagine all the poor people that got stuck waiting a month or two to get out of that investment.

Right now I have a ShareBuilder® account through ING Direct. This account works for me because it allows me to invest in any stock, EFT or mutual fund, in any amount at a wide variety of time intervals. I get fractional shares of stock and my dividends are automatically reinvested. It also offers real-time trades at a cost similar to most online brokers. Also, I can write Covered Calls through their service, which is something I am just getting into and will write more about in a future posts.

Obviously this service is not free, but compared to a traditional brokerage account I have found their costs to be much less for a dollar cost averaging investment approach. I have a Standard Account that costs me $12.00 a month and allows me to invest in up to six (6) stocks, EFTs or Mutual Funds and I if want to invest in more the cost is $2.00 per transaction. If I invested in six different stocks per month through an online broker at $9.99 per trade it would cost me $59.94 in commissions, OUCH!!

Two last words on why I have a ShareBuilder account. One, is I can execute a real time trade to either buy or sell a stock if the situation warrants. This is one feature you do not have when participating in a company’s DSPP / DRIP. Two, is I get fractional shares of stock. For example, if I want invest $400 in 3M @ $68.72 per share and use a traditional broker I would get five (5) shares and would have $56.41 left over not counting commissions. With fractional shares my $400 gets me 5.821 shares. This keeps more of my money working for me in the investments of my choice. This means 14% more dividends, 14% more capital appreciation and 14% more cash flow available for reinvestment.

Remember always buy the underlying stock if participating in a DSPP / DRIP. This is a long-term form of investing.

I’m on my second month of tracking my passive income. I had a lot of my dividend paying stocks hit this month so these results will not be repeated in July. So here we go:

June 2008

• Interest Income: $8.77

• Dividends: $116.04

• Covered Call Writing: $438.05 (see below)

Total $562.86

Looks good right? Wrong!! STLD had me on a crazy rollercoaster. Shortly after I bought the stock there was a nice big sell-off, so I closed my position effectively wiping out the $438.05 I made. Huge lesson learned. I let my long-term love for steel get the better of me so I was blinded to the short-term volatility that comes with only wanted a stock for writing Covered Calls. If I were buying STLD for the long-term through dollar cost averaging that would be fine, I can take the short term hit because as I continue to accumulate stock my costs basis will adjust down. My intention here was not to keep STLD long-term; I already have other steel stocks in my portfolio. By writing covered calls I am buying a large block of stock at once to write a call to generate cash flow. Some volatility is ok. I have downside protection because of the premium and if the stock price drop is not that big I can simply write another call next month, but STLD had me terrified.

I need to digest this and be a little more cautions before I jump into a stock. I let my excitement get the best of me. At the time of writing this, STLD is making somewhat of a comeback. I believe they report earnings on July 21^st. I’ll keep watching the stock. I still think they are going to have great results.

On a positive note I did upgrade my savings account. I bank with Washington Mutual (don’t own the stock) and they have a 3.30% Online Savings. This is a huge upgrade from my statement savings. I don’t know why I didn’t do this sooner. I guess I never paid attention to it. Anyway in July I should see much better interest.

There is another Blog a like to read it called Get Rich Slowly. The author recently had a post about other high yielding savings accounts. Here is the link: Get Rich Slowly Savings Accts. You may want to check it out.

Here are the stocks I currently have in my portfolio that pay dividends:

I will post my dividend paying stock portfolio on a quarterly basis. It doesn’t change that much so I don’t see a need to update more frequently than that. If you would like to know what other stocks I have just let me know. I like to exchange investing ideas with others.

I periodically change the mix of stocks. Rather than outright sell a stock I typically stop buying shares in it and add a new one to my portfolio. I buy almost all of my stocks through a dollar cost averaging approach. I am a huge proponent of investing this way, especially in a volatile market like we have now. It allows you to purchase more shares of a stock when the price is low and less when it’s high. Dollar cost averaging is a way for individual investors to buy a small amount of stocks and EFTs without having to commit a large sum of money for an initial investment.

Finally, in a future post I will discus how I invest through dollar cost averaging. Just to give you an idea I use a combination of a traditional broker, Direct Stock Purchase Plans (DSPPs) and Dividend Reinvestment Plans (DRIPs).

There are a ton of books on Options investing, but very few specifically on covered call writing. One book I recently read was Cashing in on Covered Calls, by Alan Ellman. I got this book off Amazon, but it was shipped directly from the author’s business / publishing company called The Blue Collar Investor.

So my initial impressions of the book were positive. It was a very easy read and provided a lot of real-life examples, which I find very helpful. The book contains a lot of basic practical advice on screening for stocks which could make good candidates for covered call writing. The book is laid out in a very logical format, it beings with all the basic definitions and “lingo” of options and call writing. It then moved onto how to create a watch list of stocks using fundamental and technical analysis. What I liked about this section is the author gives you exactly what he’s looking for when screening stocks and how he goes about his analysis.

The two most useful chapters in the book were Chapter 9 “Calculating Option Returns” and Chapter 11 “Exit Strategies” Nothing profound in these chapters, but I will follow his advice on how to calculate rates of return, downside protection and upside potential. I will reread the exit strategies chapter a few more times just to glean a few ideas. Even before I read this book I started developing an Excel spreadsheet. I hope to have it done soon and published on my Blog so you can download it.

Overall I would give this book a “B” and recommend it for someone who is new to covered call writing, like myself. If you are a seasoned investor skip this one. I would have rated it an A-, but there are a few things I didn’t like about the book. First, the book itself ends on page 187 and then there are 103 pages of appendices. That’s ok if the appendices were useful, but most of there were old email alerts from the author’s Blog and email “testimonials” from people who either took the authors seminar or subscribe to his email alerts. The only appendix I found remotely useful was VIII which lists some reference websites and books. You can tell these last 100 pages are just filler and advertising for the author’s business. Second, the book is self-published many of the charts are screen shot from Yahoo! and other websites. Finally it did not go into writing covered calls over a dividend period, using margin or the tax treatment of covered call writing. I guess those topics are more advanced and like I said this book is very basic.

So my June 19 Microsoft Call (.msfqb) expired out of the money (i.e. the closing price was below the strike price). MSFT closed at $28.55 my option strike price was $29.00. I was hoping to get called out. The stock did get above $29 for a short period of time, but just couldn’t hold on. I wanted to free up the cash to write other covered calls with higher premiums.

Since I didn’t get called out I decided to just sell the stock. The premiums on the July calls were terrible and I saw better opportunities out there. So on June 23^rd I sold 200 shares at $28.03 for net proceeds after commission of $5,600. When I calculated my final take on the sale I actually needed up losing ($149) on the stock since my average costs basis was $28.70. Oh well, I off set that with the $128 I earned on the call for a net loss of ($21.85). A small price to pay given the money I freed-up bought me 2 July 18 Steel Dynamics (STLD) Calls.

I am very bullish on steel. Why, because steel is used in everything. People are talking about the global commodities, infrastructure and energy boom. How will we get more oil? Through new rigs and infrastructure, which are made with steel. People are investing in heavy equipment made by CAT and Deere Co.; they are all made out of steel. I’ll write more on the sectors & stock I like in a later post.

So I have been watching STLD for a while, but already had Nucor and Worthington. The Street.com rates the stock an A+. All of its fundamental and technical indicators (PE, volume, moving average, etc) are strong, but the big thing for me was the premium. The premium on the July 18 $40 calls was $2.25. This means that for 200 shares I would receive $450. Not too bad!!

Since I didn’t own the 200 shares of STLD I had to do what is called a “Buy / Write”, which means I buy a position in the stock and then write the Call, all in the same transaction. Like writing the Call on my MSFT; thought my ShareBuilder® account I can do this all in one transaction. Here is how the transaction went down:

1. I selected to execute a “Buy / Write” on the options trading screen. I bought 200 shares of STLD at $40.02 (200 * $40.02 = $8013.95) w/ commission. Then simultaneously sold a July $40 call for $2.25 (200 * $2.25 = $450) less commission. So I netted $438.05. That a 7.62% return for the month or a 91.42% APR for the year.

My only regret is I should have investigated the “in-the-money” calls on this stock a little more. An “in-the-money” Call is one where the current stock prices is above the strike price of the Call. For example, if I had sold a July $35 when the current stock price was $40.02 it would have been “in-the-money” by $5.02. I would have had more downside protection in case the stock started to fall. Oh well. I’m happy making $400+ on this call and I don’t think the stock is going to lose too much value if any.

In an effort to generate additional cash flow from some of the stock I own, I decided to try writing a covered call. I have been doing some reading on the subject and it is a good way to earn addition income on stocks especially in a stagnant market such as this. I’ve looked for some other Blogs on the subject, but I really couldn’t find any that went in-depth. There were some good articles, but most Blogs just kept track of their writer’s investments without telling you the rationale behind why they decided to write that particular covered call for that stock. I will try to be more detailed in my writing.

The other sites are all pay services trying to sell you their software or a list of companies with a high options premium. I have not subscribed to any of these services and typically don’t. If so some reason I do I will be sure to cover my experience here. I am a firm believer that unless what they are selling is a unique software program you can find most of the same information in books or for free on the Internet.

For any one interested here are some other websites that provide good basic information on what a covered call is and some basic strategies.

• One of the first places I go as sort of a jumping off point is Wikipedia. Why you ask? Generally speaking the information on their site is free from advertisements.It makes it easier to separate real information from someone sales pitch and it sites references and provides links to other reputable sources. So here is what Wikipedia has to say about Covered Calls.

• The Chicago Board Options Exchange (CBOE) is another site I like. Tons of information and you can register for free. Here are two links on CBOEs site woth checking out: CBOE’s Buy-Write Index and CBOE’s Covered Call Strategy

• I also like The Options Industry Council. There are online courses you can take for free. Lots of information and a great place to start.