TK All-Star posted on 11/16/09 at 04:06 PM

Mark Wolfinger explains how to sell covered calls on deep ITM options to collect dividends.

I came across an interesting dividend strategy from a self-described options newbie, 638steamfitter. It can be a very effective play if you understand all the angles and risks. Here’s how 638 steamfitter describes the situation:

“Does anyone know the probability of a deep in the money option being exercised early? I had an idea of selling deep ITM covered calls on a high-yielding dividend stock, then taking the proceeds and reinvesting them in more stock of the same company, then selling more calls on that stock and buying more etc.

There would be no upside potential on the stock valuation but if the contracts don’t get exercised early I could collect the dividends on the stocks until the expiration of the contract. I am guessing that even if I were to sell LEAPS the time value of a contract more than 50% in the money will just be exercised early right before the ex dividend date.”

Hello steam,

The probability of being assigned early is very high – depending on the options you choose to write.

This may seem trivial, but it’s vital to your chance to earn a profit: Please remember that you must sell options that have some time value – and “some” does not mean a couple of pennies. You must pay commissions and taxes and allocate some of your capital to make the trade, so if there is no real profit potential – other than your hope to escape from being assigned an exercise notice – then there’s no compelling reason to make this investment.

Sometimes rookies sell options under parity, and it’s a big mistake. That means they sell at a price lower than the option’s intrinsic value. “Intrinsic value” refers to the amount by which an option may be currently in-the-money. For example, a 50 call is in-the-money when the underlying is trading for 52; that call has $2 of intrinsic value.

A few more points come to mind as I consider this play:

You are considering the sale of LEAPS, Long-Term Equity AnticiPation Securities; as the name implies, these are basically long-term options. In today’s low interest-rate environment, it’s even more likely that the call owner will elect to exercise the option for the dividend. Why? One reason for owning options instead of stock is to use less cash for the investment. The residual cash can then be invested to earn interest. When interest rates are higher, the interest you can collect on that extra cash will be juicier than the value of the dividend. Since interest rates are at historic lows right now, the opposite is true; dividends are looking more attractive, which encourages folks to exercise.

Exercising an option involves risk for the exerciser. Owning calls – whether LEAPS or short-term – has the advantage of limiting your losses if the stock takes a big dive. We all recognize that solid companies that pay nice dividends seldom take big dives – in theory. The shareholders of GM and the big banks may feel otherwise these days.

The point is that by exercising, the call owner is trading that dividend for the synthetic equivalent of a put option with the same strike price. (TradeKing All-Star Dan Passarelli recently explained this point nicely in his post, “Deep ITM options, or just own stock?” )

You know when an option should be exercised for the dividend: when the option’s time premium is zero and delta is 100. (Zero time premium means you cannot sell the option above its intrinsic value — or the amount by which the stock price exceeds the strike price.) 100 delta on a call means that the call is trading in lock-step with the underlying stock; that is, a $1 move in the underlying stock will probably cause a $1 move in the price of the option. Brian Overby’s recent beginner posts on delta will explain this more.

Exercising also starts to look appealing when the price of the corresponding put (same strike and expiration date) plus the cost of owning stock all the way through expiration is less than the dividend.

You can increase your chances of collecting the dividend by writing a call (LEAPS or otherwise) with a slightly higher strike price, that is selling less deep in-the money. You want the call to have a high delta, maybe 80+, but not be near 100.  This incurs a bit more downside risk for you, but it also creates a better opportunity for you to collect the dividend.

If you do get to receive the dividend on that LEAPS call, don’t forget: three months later, the dividend situation will arise again. With less time to expiration on the LEAPS, there’s also a lower cost to own the stock through expiration; both those factors may encourage the call owner to exercise.

Bottom line: don’t expect to collect four dividends from a 12-month option.  But depending on the stock price relative to the strike price (that determines the option delta), your chances are good for collecting up to 3 such dividends.

Thanks for the great question!

Regards,

Mark Wolfinger

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Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Community, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.

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