Dividend Capture using Covered Calls

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Dividend Capture using Covered Calls

By: ip –> Post on: 10 Июнь, 2020 No Comment

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date.

Many people have tried to buy the the shares just before the ex-dividend date simply to collect the dividend payout only to find that the stock price drop by at least the amount of the dividend after the ex-dividend date, effectively nullifying the earnings from the dividend itself.

There is, however, a way to go about collecting the dividends using options. On the day before ex-dividend date, you can do a covered write by buying the dividend paying stock while simultaneously writing an equivalent number of deep in-the-money call options on it. The call strike price plus the premiums received should be equal or greater than the current stock price.

On ex-dividend date, assuming no assignment takes place, you will have qualified for the dividend. While the underlying stock price will have drop by the dividend amount, the written call options will also register the same drop since deep-in-the-money options have a delta of nearly 1. You can then sell the underlying stock, buy back the short calls at no loss and wait to collect the dividends.

The risk in using this strategy is that of an early assignment taking place before the ex-dividend date. If assigned, you will not be able to qualify for the dividends. Hence, you should ensure that the premiums received when selling the call options take into account all transaction costs that will be involved in case such an assignment do occur.

Example

In November, XYZ company has declared that it is paying cash dividends of $1.50 on 1st December. One day before the ex-dividend date, XYZ stock is trading at $50 while a DEC 40 call option is priced at $10.20. An options trader decides to play for dividends by purchasing 100 shares of XYZ stock for $5000 and simultaneously writing a DEC 40 covered call for $1020.

On ex-dividend date, the stock price of XYZ drops by $1.50 to $48.50. Similarly, the price of the written DEC 40 call option also dropped by the same amount to $8.70.

As he had already qualified for the dividend payout, the options trader decides to exit the position by selling the long stock and buying back the call options. Selling the stock for $4850 results in a $150 loss on the long stock position while buying back the call for $870 resulted in a gain of $150 on the short option position.

As you can see, the profit and loss of both position cancels out each other. All the profit attainable from this strategy comes from the dividend payout — which is $150.

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What is the risk in capturing dividends using a covered call?

I am looking at this example to capture dividends using long stock and covered call.

What is the risk in this strategy? There is no delta risk, since the position is delta neutral. So it seems like I am just going to collect the dividend without any risk., Looks like a free lunch.

Please point out the catch :)

2 Answers 2

Typically the catch is liquidity, and the margins are pretty small, so you can’t just leverage up and make a percentage off that. Typically you’ll be trapped in the options position.

Ignoring that XYZ at $50 is paying what is assumed to be a quarterly dividend of $1.50 (12% a year?), there are two risks.

The first is that your $40 covered call is most likely going to be assigned before the dividend.

The second, though slim, is that the stock gets clobbered and drops below the strike price. It’s only hedged above $40.

Using Covered Calls to Capture Dividends

Take a second and think back to when you first learned about dividends. At some point, most of us have probably asked ourselves one very similar question: can we buy shares right before the ex-dividend date, collect the dividend, and then sell the shares immediately afterwards for a profit?

If you’ve tried this little scheme, then you’ve likely discovered a disappointing reality. On the ex-dividend date, the share price of the equity decreases by the value of the dividend. However, trading call options provides us with a unique opportunity to try and capture a risk-free profit as the stock goes ex. The trade will be constructed around the writing of covered calls. Obviously, we will need to find a stock with an approaching ex-dividend date, and a desirable dividend amount.

The process is as such:

  1. Calculate the intrinsic value of a deep in-the-money (ITM) call based upon the spot price in the equity, and then add the premium of the corresponding strike put.
  2. Assume that you can sell the call at the cumulative price. Realistically, you are going to have to offer this call and/or look for a bid that satisfies the required cumulative premium if the spot price of the equity changes, which it will.
  3. Per each call sold, buy an amount of shares equal to the option’s multiplier (typically 100, unless you are trading mini or jumbo options) at the reference spot price used to calculate the intrinsic value. Make sure you can trade the equity at this price or better. If you cannot, you must cancel your call offer and/or do not hit a bid in the call that you have been eyeing.
  4. You are now long the equity and short a 100 delta call. Essentially you just executed a buy-write. The stock and call will change in value equally with every tick. You are hedged and will just have to wait for the results on the ex-dividend date (which is assumed to be tomorrow). You can obviously construct this trade before the ex-dividend date, but that just adds extra time for the calls to be assigned to you. But you may also be able to sell more time value in the call.

On the ex-dividend day, if you did not receive a notice from your broker that you are being assigned on your short calls, then you will receive the dividend. Receiving such a notice might possibly occur in the event that a large percentage of counter-parties forgot about the dividend, or it was a surprise dividend not widely known. Otherwise though, your position will remain until expiration, or until you find an opportunity to buy back the call and sell the equity.

The caveat to this strategy is that buyers will typically early exercise the contracts. If this happens, you will no longer receive the dividend from the underlying. When the buyer of a call exercises her right to own the stock, she technically purchases the equity on that trading day and qualifies for the dividend. That dividend right becomes your obligation, which is offset by your long stock.

However, you will still come out on top if there was some time value remaining on the corresponding strike put. When the call is assigned, you are essentially buying back a short option. Your long stock position should offset the combined value of the strike price of the call and its intrinsic value. If the long stock price minus the strike price is less than the price of the call sold, then you’ve made some extra money (i.e. the time value of the put). Even though that premium may be much less than the free dividend that you were hoping for, it’s still free money. That is, as long as your transaction costs were not greater than your consolation prize.

We will conclude with a quick example.

Let’s say we have decided that company “X” is paying a cash dividend that we would like to capture. The ex-dividend date is set for the last day in October, Aka Halloween. The yield of the dividend is set at 5%, and company “X” is trading at $50 per share. Therefore, the cash dividend will be $2.50 per share acquired (50 x 0.05 = 2.50). On October 30 th , we will purchase 100 shares of company “X” for $50 ($5,000 capital). On that same day we will also write (sell) 1 40 call of company “X” and collect a premium of $10 ($1000 capital).

On Halloween (the ex-dividend date for company “X”), the price of company “X” drops by $2.50 per share from $50 to $47.50. Since our call was deep in the money, the price of the 40 calls we sold also drops by a similar amount to $7.50. The next day, the buyer of our calls has not exercised them. Springing into action, we sell our shares of company “X”, now worth $47.50 ($4750 capital), and buy back the calls we sold for $7.50 ($750 capital). Shortly thereafter, we receive our cash dividend and conclude our trade with a profit of $250.

7 Dividend-Capture Ideas Using an Option Hedge

May 24, 2020 6:00 AM EDT

NEW YORK (TheStreet) — Quarterly dividends can be a great source of income. With each dividend payment received, investors are able to lower their risk. Investors need to be a shareholder on the day of record for the dividend. To qualify as a shareholder of record you must buy the stock before it trades ex-dividend and keep it until the ex-dividend date.

Using call options for hedging is one of my favorite and easy-to-understand methods of capturing gains through options and dividends. This method can be used to capture more than one option by holding them longer than three months.

I sorted by highest yield first and

Ares Capital (ARCC) – Get Report

is the highest with a yield of over 9%. Ares Capital is a credit-focused private investment adviser.

Yield: 9.74%

Dividend Amount: 37 cents

Ex-Dividend Date: June 13, 2020

Beta: 1.79

Strategy:

Buy Ares Capital stock and sell the June $15.00 strike or lower call for 25 cents over the intrinsic value. I sell the call option first to ensure the stock option leg is complete.

The option strike has an encouraging open interest over 800.

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and recommend it. It is easy to make mistakes when starting out on a new strategy and mistakes cost a lot less with a simulated account. After a level of confidence is built, then it may be time to move into a real money account.

It is important to sell the call option hedge at or near the asking price for at least the minimum amount over intrinsic value. I don’t want the option hedge unless the sale will provide at least the minimum 25 cents over intrinsic value.

If my shares are called away before trading ex-dividend (resulting from the option buyer wanting the dividend), I gain about 25 cents. The most I can make is 62 cents if I hold the covered call through option expiration day and the stock gets called away.

My last step (completed before making a trade on the same day) is to check company announcements and news sources for possible price moving events. This is especially critical during earnings season.

Digital Realty Trust (DLR) – Get Report

Digital Realty provides a wide range of data center solutions and consultation, including building, buying, managing, and data center outsourcing services.

Yield: 4.19%

Dividend Amount: 73 cents

Ex-Dividend Date: June 13, 2020

Beta: 1.06

Strategy:

Buy Digital Realty Trust stock and sell the June $70.00 strike or lower call for $1.46 over the intrinsic value. I will look to close out the covered option with a gain of about 65 cents, plus the quarterly dividend paid by the company.

The most I can make is $2.19 if I hold the covered call through option expiration day and the stock gets called away.

T. Rowe Price Group (TROW) – Get Report

T. Rowe Price Group, Inc. is a publicly owned asset management holding company.

Yield: 2.34%

Dividend Amount: 34 cents

Ex-Dividend Date: June 12, 2020

Beta: 1.61

Strategy:

Buy TROW stock and sell the June $50.00 strike or lower call for 56 cents over the intrinsic value.

The option may get exercised early for a gain. If not, after qualifying for the dividend I will attempt to close out the trade with a gain of near 20 cents, plus dividend.

If my shares are called away before trading ex-dividend (resulting from the option buyer wanting the dividend), I gain about 56 cents. The most I can make is 90 cents if I hold the covered call through option expiration day and the stock gets called away.

Eastman Chemical (EMN) – Get Report

Eastman Chemical, a chemical company, engages in the manufacture and sale of chemicals, plastics, and fibers.

Yield: 2.27%

Dividend Amount: 26 cents

Ex-Dividend Date: June 13, 2020

Beta: 1.97

Strategy:

Buy Eastman Chemical stock and sell the June $35.00 strike or lower call for 75 cents over the intrinsic value. I will attempt to close out the trade with a gain of near 32 cents, plus dividend.

XL Group (XL)

XL Group, through its subsidiaries, provides insurance and reinsurance.

Yield: 2.16%

Dividend Amount: 11 cents

Ex-Dividend Date: June 13, 2020

Beta: 2.43

Strategy:

Buy XL Group stock and sell the June $20.00 strike or lower call for 60 cents over the intrinsic value. I will attempt to close out the trade with a gain of near 26 cents, plus dividend.

If my shares are called away before trading ex-dividend (resulting from the option buyer wanting the dividend), I gain about 60 cents. The most I can make is 71 cents if I hold the covered call through option expiration day and the stock gets called away.

Comerica (CMA) – Get Report

Comerica, through its subsidiaries, provides financial products and services.

Yield: 2.04%

Dividend Amount: 15 cents

Ex-Dividend Date: June 13, 2020

Beta: 1.21

Strategy:

Buy Comerica stock and sell the June $29.00 strike or lower call for 79 cents over the intrinsic value.

After qualifying for the dividend, I will attempt to close out the trade with a gain of near 23 cents, plus dividend.

If my shares are called away before trading ex-dividend (resulting from the option buyer wanting the dividend), I gain about 79 cents. The most I can make is 94 cents if I hold the covered call through option expiration day and the stock gets called away.

Motorola Solutions (MSI) – Get Report

Motorola Solutions provides communication infrastructure, devices, software and services.

Yield: 1.84%

Dividend Amount: 22 cents

Ex-Dividend Date: June 13, 2020

Beta: 1.63

Strategy:

Buy Motorola Solutions stock and sell the June $46.00 strike or lower call for 95 cents over the intrinsic value. I will look to close out the covered option with a gain of about 50 cents, plus dividend.

The most I can make is $1.17 if I hold the covered call through option expiration and the stock gets called away.

Ecolab (ECL) – Get Report

Ecolab develops and markets programs, products, and services for the hospitality, food service, health care, industrial and energy markets.

Yield: 1.24%

Dividend Amount: 20 cents

Ex-Dividend Date: June 15, 2020

Beta: 0.69

Strategy:

Buy Ecolab stock and sell the June $62.50 strike or lower call for $1.08 over the intrinsic value. I will look to close out the covered option with a gain of about 45 cents, plus dividend.

If my shares are called away before trading ex-dividend (resulting from the option buyer wanting the dividend), I gain about $1.08. The most I can make is $1.28 if I hold the covered call through option expiration day and the stock gets called away.

DISCLOSURE: Author does not hold a position in any stock mentioned.

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