Cover Calls Attractive with Market High
Jonathan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
With the Dow Jones Industrial Average hitting record highs, this has become a market for writing covered call options. Last June, my first article as a blogger for The Motley Fool, “Writing Covered Call Options on Big Oil Could Yield Big Gains,“ detailed the benefits of writing covered call options on Big Oil stocks such as Chevron (NYSE: CVX) and Occidental Petroleum (NYSE: OXY). Now that the Dow has surged so strongly with recent weakness showing, Foolish investors should look at writing covered call options on dividend paying stocks such as Chevron, Occidental, Microsoft (NASDAQ: MSFT) and Intel (NASDAQ: INTC) to protect gains and generate income.
As I wrote last June, “Writing covered call options entails selling the right to buy shares of a stock you own within a set period of time. This is transacted through a call option of which the option buyer has the right to buy the underlying stock of the contract at a set price. On the flip side, the option writer has the obligation to sell the underlying stock at the contract price upon exercise from the option buyer.”
According to Mike Scanlin of www.borntosell.com, “Covered calls are an easy and conservative income-oriented investment strategy.” This website provides a calculator for Foolish investors to determine what could potentially be earned by writing covered call options. Utilizing that tool, a Foolish investor owning 1,000 shares each of Chevron, Occidental Petroleum, Microsoft and Intel could possibly generate substantial income from writing covered call options on each, as shown by the table below.
Source: www.borntosell.com (*annualized return)
While those returns are just projections, we know that income can be earned in different ways when writing covered call options. The first is from the actual sale of the covered call option. As about 80% of options are never exercised, this is a very good way to profit from owning a stock since the odds are strongly in favor of the holder getting to keep the stock after the expiration date.
Next, gains are made if the stock is sold at a higher price than when it was purchased. If Chevron was around $100.00 per share and sold now at $121.00, there would a profit of over $20 per share from the transaction. That goes to the owner of the stock, not the buyer of the call option. If Chevron were to fall in price, the call option would not be exercised.
In addition to the capital gains, the owner of the shares gets to keep the dividend income that's paid during the option period. For Chevron, Occidental Petroleum, Microsoft and Intel, that's not a minor consideration as each has a robust dividend. While the average dividend for a member of the S&P 500 is around 2%, for Chevron it is 2.97%, Occidental Petroleum it is 3.25%, Microsoft it is 3.26% and for Intel it is 4.22%.
When you write covered calls, your goal is to keep your shares and still book the income from selling the options and cashing the dividend checks. Stocks that have risen, but do not appear to have much upside left, with strong dividend income are the ideal candidates. As the table below shows, Chevron, Occidental, Microsoft and Intel are all up for 2013. Chevron is very close to its 52-week high, with Microsoft near its peak for that same time period.
Based on that, and indicators that point to it being overvalued, such as a relative strength index rating of 70.46, signaling that it has been overbought and both its price-to-sales and price-to-book ratio being higher than the industry average, according to The Motley Fooll CAPs, Chevron looks to be a promising stock for the Foolish investor to book profits from writing cover call options and still keep the shares.
Jonathan Yates has no position in any stocks mentioned. The Motley Fool recommends Chevron and Intel. The Motley Fool owns shares of Intel and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!