Dividend capture with covered calls—too hot, too cold, or just right!

Thursday, April 15th, 2010

If you have general questions about dividends see Top 10 questions about dividends.

One strategy for capturing dividends is to buy the stock/ETF and then sell calls against that security as a hedge—a covered call.  The value of the short calls moves in the opposite direction of the stock/ETF, providing a hedge.   There are three major variables with this strategy:

1. How many days before the ex-dividend date do you put the position in place?
2. What strike price do you select for the options?

3. How many days until the options expire?

Your risk profile, playing with these variables, can be generalized into the three situations below:

Too cold (too low a risk)    Calls too deep in the money
  • If you sell deep in the money (ITM) options you may feel you’ve found the golden goose.  The calls provide a great hedge, virtually eliminating risk from your position.   Unfortunately, your calls will almost certainly be assigned the evening before the ex-dividend day.  The owners of the calls are not about to let you get away with collecting dividends with such low risk, so they exercise the option you sold them.  They call away your stock and they collect the dividend.  Your position is closed out—no dividend for you.  The only profit you might have is from any premium present when you created the position (if your net investment was less than the strike price).   Some people use this strategy hoping that their options will not be assigned, and not all are, but in my experience the percentage not assigned is very low.

Too hot  (too much risk)    Calls without enough hedge value,  calls that don’t expire for a long time

  • If you sell options that have a strike price that is at or above the current market price of the stock/ETF you can collect a significant premium, and signficantly lower the risk of having your stock assigned.  However, since the value of the options is relatively small (perhaps .5% of the value of the stock) you don’t have much downside protection.   A few bad days on the market can wipe out a year’s worth of dividend capture profits.
  • Not having your stock assigned is good from a dividend collection standpoint, but it is bad if your options have weeks until they expire.  If your calls have a while to run you will see the premium on your unassigned options increase by about the amount of the dividend on the ex-dividend day.   Since you are short these calls your net profit on ex-dividend day will be about zero.   Until the premium on the option decays away, ultimately going to zero at expiration, your position is usually not profitable.   While you wait for the premium on the call to decay you are exposed to market risk—this can be very unpleasant.

    • Just right
    • What I have found to be a good combination is:
      • Find stocks/ETFs where the options will expire within 10 business days of the ex-dividend date
      • Create the covered call position about a week before the ex-dividend date
      • Choose a strike price that gives you a premium about equal to the dividend value.
    • This recipe will usually result in a covered call position that will be assigned on the evening before the ex-dividend date.  You typically don’t collect the dividend, but since the option is closed out you keep the option premium which is roughly equal to the dividend amount.
    • The calls will provide a decent hedge against risk.  Not enough to protect against a major market move, but they do provide significant protection
    • If the stock/ETF value goes down after you put the covered call in place then the chances of call assignment decrease—bettering your chances of collecting the dividend.  If you do collect the dividend  the breakeven point on your position is improved, and your maximum profit potential goes up by the dividend amount.
    • If the bid / ask spreads on the stocks / options are significant you will probably need to use a combo order to get a decent profit potential.
    • While ok in flat or rising market—this position will not hedge a serious bear move—be prepared to bail out if the market goes seriously south

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    • Anonymous

      The strategy you describe here is very close to the Inflatable Dividends strategy on my website.

      It basically looks for the highest annualized return on covered call dividend capture trades expiring at the upcoming expiration date. The daily data lists out how many days until expiration and how many days until ex-dividend for each possible trade.

      There’s a 60-day free trial.

      http://www.dividendium.com/PremiumServices_InflatableDividends.aspx

    • Hedge

      Since naked puts have the same exact risk:reward profile as covered calls, but with only one commission fee, you can use a somewhat in-the-money naked put expiring a bit before the ex-date to similar effect. If you are assigned on the put, then write a call against the shares assigned and wait for ex-date. You might actually collect 3 different ways. Sorry if this is discussed elsewhere here – I have not yet read the entire interesting website.

    • vance3h

      I agree that naked puts are equivalent to covered calls, including dividend considerations. I have collected twice sometimes with a covered call dividend capture strategy when my calls weren’t assigned at ex-dividend, and then expired in the money.

      However I would not expect a put expiring before an ex-dividend date to show any dividend effects, nor would I expect it to be likely to be assigned. Shifting stock you own to someone else, or going short on a stock before ex-dividend doesn’t seem like an attractive dividend strategy for someone that is long puts.

      ITM puts expiring relatively soon after ex-dividend exhibit low IVs before the ex-dividend date that go back to normal on the ex-dividend date of the underlying. If you are short those puts early enough before the underlying goes ex-dividend you should benefit from the IV drop–but then you are exposed to the normal volatility of the underlying.

      I could easily be missing something here. Can you lay out a scenario for me?

      – Vance

    • Gary Holt

      Are you saying that calls can be assigned after the market is closed?

    • Vance3h

      Hi Gary,
      Yes, they can be, and I expect the vast majority of the assignments are done after market close (mostly in-the-money options at expiration). This link http://www.tradeking.com/FAQ/Trading/optionsAssignment.tmpl#ques5 gives more information. For retail customers I think it depends on the broker–one reference I saw said typically notification must be delivered within 15 minutes after market close.

      – Vance

    • Valjean

      Vance,

      It’s been a year since you’ve published this strategy. I was wondering: Are you still using it? And how is it doing for you?

    • Vance

      Hi Valjean,
      Of the dividend capture strategies I think this is still the best I’ve found. I’ve also looked at doing dividend capture on IEF with DTYS, but DTYS isn’t a good enough hedge. I haven’t been doing the dividend capture strategy for around 6 months because the downside risk in this choppy market seems large compared to the relatively small maximum profit potential.

      Sheldon Natenberg, author of “Option Volatility and Pricing” recently mentioned in an interview that covered call owners are effectively short on volatility, because you prefer the market to stay flat or go up, both low/dropping volatility situations. He suggests adding a long volatility position to hedge out the volatility risk. Being long on volatility can be an expensive proposition, but in a short term dividend capture situation it might make sense. Buying OTM VIX options,or OTM SPY puts might be a cost effective way to to that, but I need to look to see how expensive it will be to truly hedge the risk.

      – Vance

    • http://moneymakingstockpicks.com Option Trading Strategy

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