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


Updated: Dec 29th, 2016 | Vance Harwood

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 an in the money 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


For more information:

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Thursday, December 29th, 2016 | Vance Harwood
  • 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

  • My brother recommended I may like this blog. He was totally right. This submit actually made my day. You can not believe just how a lot time I had spent for this information! Thanks!

  • Burt

    I have a question, please:

    The Trade:
    1. I sell a naked at the money Call 1 day prior to ex Dividend date.
    2. My aim is for the stock I do not own to be called away. Effectively, on ex Div date I will be short the stock.
    3. On ex Div date, the stock price dips equivalent to dividend value.
    4. On ex Div date I bail out of my short position. I buy back the stock and close the trade. Thus, I capture the dip in stock price equivalent to dividend and also profit from the premium on the Call sold.

    Example:
    a] Stock Y price is 100. Dividend due is 0.75.
    b] I Sell a Call one day prior to ex Div date on stock Y at strike 100 for $1.
    c] Next day, ex div date, stocks gets called away and I am short Y stock at 100.
    d] Price of Y stock on ex Div date falls to 99.
    e] I buy back the short position at 99 to close the trade.
    f] I made $1 in stock price dip and $1 as Call premium = $2.

    The Questions:
    I. Am I correct in my assumptions and calculations as per example above?
    II. I read somewhere that given this particular situation or trade, I am liable to pay the broker (or whomsoever) a sum equivalent to dividend. Is this true?
    Appreciate some informed advice, please.
    Thanks!
    Bharat
    yet786@gmail.com

  • not sure about this…

    “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.”
    Is this true? Let’s say I was going to buy an ATM call on a $100 stock and pay 50 cents. I can exercise early and get a 40 cent dividend. The day the stock goes ex dividend, I would be willing to pay 40 cents LESS because I no longer have the chance to exercise and capture the dividend. Call option value FALLS on ex dividend date, as the right to buy the stock is now worth 1 dividend payment less.

    Also this site/disqus might be wonky: the post date is April 24th 2015 but the Dividendium comment below was made “6 years ago.”

  • If your analysis was correct there would be a sure profit in being short calls when stocks go ex-dividend. The market is very good at eliminating opportunities for sure profits. If you look at actual data call premiums do not vary much when stocks go ex-dividends. The implied volatility of the options jumps up enough after the dividend to compensate for the loss of value due to the dividend no longer being priced into the option’s value.

    Regarding the post date, this post was first posted in 2010, the date shown is the latest update. I have modified the blog so that it now shows “Updated” next to the date shown.

    Best Regards,

    Vance

  • Franc

    The value of the short calls moves in the opposite direction of the stock/ETF?

    Frank

  • Tim Schaeffer

    I came across your website because I was thinking of buying high-dividend stocks and selling deep-in-the-money covered calls with very long expiration dates (2017-2018). But your comments make me wonder whether you can make money instead by e.g. buying a deep in the money Jan 2018 call on NLY, exercising just before ex-d, collecting the dividend, and then selling the same call. Thoughts?

  • Hi Tim,
    People with very sharp pencils have made it very hard to profit from dividend plays. If you look at specifics I think you’ll see that the premium you’d get for your Jan 2018 call probably wouldn’t even cover your commission. The mid-price of the bid / ask is 5.85 for the $5 strike with NLY at 10.84. There’s no guarantee you’d get a fill at the mid-price either. If there’s no premium then the only advantage of the trade is downside protection–at the cost of giving up the upside.

  • Yes. You can think of an in-the-money short call as shorting the stock/ETF, but the strike price of the option acts to limit the possible profits. If the value of the security drops below the strike price the short call has no value at expiration.

  • walt

    Why create the position a week before ex-dividend? Why not do it the day before ex-dividend? Also, would the chance of not being assigned increase if expiration was 4 to 5 weeks after ex-dividend?

  • Hi Walt, Right before ex-dividend you’ll have a hard time getting any premium on selling an in-the-money call. On ex-dividend your call will be assigned, your stock is gone and you don’t get the dividend.

    For a call with longer to expiration it depends how much premium is available on the call. If it very deep in the money, low premium, it will likely be assigned. If the premium is comparable to the dividend then it probably won’t be assigned.

  • Walter Nadarzynski

    Suppose that I sell ten calls of a particular series the day before ex-dividend and my time premium is equal to half the dividend and the calls are in the money. Also suppose that there is no other open interest in this option besides my calls, meaning that the market maker holds the corresponding ten long calls. Would the market maker exercise his calls in this instance?

  • For the scenario you describe I’d give it around a 50-50 chance that the calls would be exercised.

  • Walter Nadarzynski

    Could you please explain why you think there is a chance that the calls would not be exercised?

  • Walter Nadarzynski

    I looked at the options tables for a stock that just went ex-dividend. There was no assignment unless the time premium was zero the day before ex dividend, regardless of expiration date. Calls with a non-zero time premium remained in the open interest on ex-dividend day.

  • mickeystoys1972 .

    an easy way to figure out if you will be assigned is to check the call you sold or plan to sell. If the extrinsic value of the sold call plus the price of the put at that same strike is less than the amount of the dividend then you will be called away.

  • grouchyjaysfan

    Hi, are you saying that any in the money option with no time premium (ie all intrinsic value) will all be assigned day before ex dividend regardless of how much time is left. ie 1 week option versus 1 month option

    shouldn’t the open interest on these options then go to zero after ex div? I noticed that there is still open interest on the weekly options which I don’t understand. thanks

  • K-Man

    I have tried this many times and it is very hard, almost impossible to make money. Example: you want to buy a $100 stock which will pay a $1 dividend soon, then try to sell a 90 call for more than $10.
    The question is where will you find a fool who will pay more than $10 for that call when they know the stock is going down tomorrow by $1 when it goes ex-div. Would you buy such a call? Thought so.
    I have never been to pull it off even though I’ve tried putting in limit orders many times. The quotes for ITM calls around ex-div dates are kept very wide, and you can’t get a fill at mid-point.
    Vance – you correctly note that there might be a sweet spot if you go for low premiums and do it a week or more before ex-div, but that exposes you to significant risk that over that time frame the stock could drop. If you believe it will not drop, it’s easier to collect a premium by just selling a naked put at that strike. Less commissions, too.

  • 2ndMouse

    Some insights I can share on this ex-div thing:
    1. The run-up to ex-div is likely to have some component of share buyback driving it. Shares bought back by the co paying the dividend reduce the shares that a co needs to pay dividends on and reduce the shares outstanding producing a permanent gain in price, more or less.
    2. Just because a company pays a dividend doesn’t mean it stops earning money. Duh! Dividends come from earnings for the most part and a healthy company will recover the value lost from paying a dividend in a month or so.
    3. Most dividends are typically much less than the daily average true range of the stock. So typical noisy price fluctuations can easily recover the pre-ex-div price just by random chance.
    4. Call option prices increase on ex-div. If the call option before ex-div is reduced by the dividend obligation then the call option should increase on ex-div, all things being equal, since the dividend is no longer in play. You can sell the call post-div on stock that you purchased within the dividend period.

  • 2ndMouse

    if the extrinsic value of the call is greater than the dividend then the call will not get exercised-early on ex-div. if smaller than the divy then it is a crap-shoot for early-exercise. know your options!

  • 2ndMouse

    Yes. The short stock position you acquired will obligate you to pay the dividend. Still you netted 1.25, not bad. However, it is not likely that you will get early exercise if the the extrinsic value of the option is greater than the dividend, that would mean someone was willing to give up $1 selling the option in the open market to collect 75 cents.

  • 2ndMouse

    Keep in mind that this drop in price on ex-div is not a lock, just typical. Sometimes big buyers wait for a stock to get clear of the dividend. ex-div gap-up’s can happen.

  • Thanks for your contributions. I mostly agree, but I’m a bit more skeptical than you about a company stock price recovering back to its pre-dividend levels within a month or two. Macro market issues can add a lot of uncertainty to that which people tend to forget in a bull market.

    — Vance

  • 2ndMouse

    The future is uncertain, eat dessert first! You are right though, macro conditions will, uh, trump, any technical condition. So just put that $ in the mattress for the next 4 years.