Capturing dividends with covered calls—are you ready?

In a recent post I gave an overview of dividend capture strategies.

In some situations, an effective way to hedge risk with a dividend capture strategy is to use covered call options.  If you are not familiar with options this might sound exotic, but it’s truly the training wheels of option trading.  With covered calls, you can introduce yourself to the conservative, hedging possibilities of options while increasing your odds of making modest amounts of money.   Before getting into the details,  please review the checklist below, to see if you are ready/able to do this:

• Do you have enough capital?
  • This strategy requires you to buy hundreds of shares of stock to make it worth your trouble, do you have the money?
  • You can use margin to buy the stock, but that will increase your costs.
• Will you be content with a small gain?
  • This strategy is generally not effective with stocks with large dividends (e.g. 4% or higher).  It works better with stocks that offer annualized dividends in the 2% to 3% range
  • On the good news side, you generally get the small gain with less than 10 business days of investment
• Does the stock/ETF you want to capture the dividend on have an active option market?
  • If the options are thinly traded, or if appropriate strike prices are not available this strategy does not work
• Are you set up for at least the first level (simplest level) of options trading in your brokerage account?
  • If your account is not an IRA then you will need to have a margin account.  Don’t worry, there are no interest charges or chance of a margin call with this strategy (assuming you don’t buy the stock on margin)
  • This first level of option authorization usually allows covered calls and simple purchases/sales of puts and calls
  • Typically you can do these sorts of trades in a Roth / Traditional IRA — however you do need to apply for that capability if you don’t have it already
• Are you willing to learn about combo orders? These are orders that simultaneously fill your stock and options orders at a not-to-exceed price
  • These orders are prudent to use in fast-moving markets, and when bid/ask prices are widely separated
  • Combo orders are not necessary if bid/ask spreads are small and if you are willing to do fast sequential market orders

Extra Credit

• Can you make your investment in an IRA account?
  • If so, this dividend strategy is more attractive, because you can defer taxes on any gains

Pass the test?  In this post I’ll give some screening criteria for good positions and the basic setup of this dividend capture strategy.