- The call writer collects the premium up front.
- The covered call writer earns any dividends paid on the call-covered stock.
- The call writer may realize the gain when the underlying stock price goes up.
For example, AT&T is trading at $35. The strike price of $37 calls, 9 months out to expiration, is trading at $1.00. The stock is paying a dividend of $0.40 per quarter.
In this example, we are writing a call that will expire 9 months later, so we'll collect $1.20 ($0.40 x 3) per share worth of dividend. The cost of a covered call position will cost $34.00 ($35.00 – $1.00).
9 months later, if the stock trades at or above the strike price at expiration, the position will generate profits of $1.00 in the covered call sale, $1.20 in dividends, and $2.00 ($37.00 – $35.00) in price appreciation. That is a total of $4.20 on a net investment at the cost of $34.00 for just 9 months. The ROI turns out to be 12.35%.
What happens if AT&T goes down? Using the same example from above:
- Bought at $35.
- Wrote a call at $1. The call expires in 9 months.
- 9-month worth of dividend is $1.20.
4 months later, the stocks is trading at $33. We have a few options since we are now incurring some losses, $0.60. [$33 - ($35 - $1 - $0.4)]
We can buy back the call and then write another one at a lower strike price. Let's say we buy it back at $0.65. We then write a $36 call at $0.9. Our new cost basis is now $35 - $1 + $0.65 - $0.9 = $33.75. Taking the 40 cents of dividend we have already collected, we now have a loss of $0.35, which is a better result than not writing any call at all. Without the covered calls protection, the loss would have been $1.60 ($33 - $35 + $0.40).
The purpose of the dividend-paying stock covered call writers is to earn steady income by collecting the premium and earning dividends with controlled risks.
Another benefit of writing covered calls on dividend stocks is the ability to collect the dividend. Ideally, the dividends will support the stock price even when the overall market is bearish. This will help us reduce the risks.
Finally, in a directionless market, the strategy should generally outperform the market averages, as the proceeds from option writing would add to the returns on the long stock positions without leaving much money on the table from those few stocks that did well in a market moving sideways.