DITM call writing to increase dividend yield

[Ross812]

I've been considering the idea of buying shares in dividend paying blue chips and immediately selling deep in the money 1-2 year leaps (~50% of the stock price) to increase the dividend yield.

 

A couple examples:

 

100 JNJ @ 63.95 = $6395; Dividend is 2.28 per year

Sell January 2014 $35 call for $2880

Outlay: 6395-2880= $3515

In January 2014 option is called: $3500 + $456 (2 years at 2.28/yr) - 3515 = $441, 6.27% annually

 

100 T @ 28.80 = $2880; Dividend is 1.72 per year

Sell January 2014 $15 call for $13.75

Outlay: 2800-1375= $1505

In January 2014 option is called: $1500 + $344 (2 years at 1.72/yr) - 1505 = $339, 11.26% annually

 

The only way to lose capital would be a if the equity fell below the stike of the call option or if the option is excercised prior to recieving enough dividends to cover expenses. Selling DITM options appears to be a way to collect a nice yield while maintaining a ~50% hedge and eliminating interest rate risk.

 

Does anyone know of something I haven’t considered? Are there any other risks I should be aware of? What would cause the LEAP options to be excercised early? What are the tax implications are of selling DITM leaps ? ect… 

 

 

 

[Tim Eriksen]

In your examples you wrote that you would sell a January 2014 put.  I think you mean sell a call.

[Ross812]

Thanks Tim! I did mean a call. I corrected it!

[BargainValueHunter]

How much of the call is intrinsic value and how much is time value?

[Ross812]

When writing a DITM call in the examples above. The value of the call is 100% intrinsic. In the case of AT&T bellow, you preserve your capital as long as T's stock price exceeds $15 in January 2014. You collect 8 quarters of dividends. I built a mock portfolio of KO 18%, JNJ 18%, MO 14%, VZ 14%, T 13.5%, BP 9%, INTC 9%, NLY 4.5%. Selling DITM calls on the above securities at roughly 50% their current stock price yields an annual return of 9.6%. The only way to lose capital that I am aware of right now is a decline in stock price greater than 50%.

 

This is essentially the opposite of what Ericopoly was doing by buying DITM calls for cheap/free leverage. Essentially by selling the call, you are selling cheap leverage to a buyer seeking capital gains. This frees principal allowing you to compound your own money more quickly and protecting yourself from a 50% downward move. 

[tradevestor]

I don't have experience, but I searched and found this.

 

http://sixfigureinvesting.com/2010/04/dividend-capture-with-covered-calls%E2%80%94too-hot-too-cold-or-just-right/

 

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. 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.

[Kraven]

It works in theory, but probably not in practice.  Take your JNJ example.  Someone buys the call from you for $2880 (using your numbers).  They now have the right to call the 100 shares from you at $3500, for a total outlay not including commissions of $6380.  This is $15 less than your total outlay.  The dividends are $0.57/quarter.  So assuming the price stayed constant they could call it from you today for a $15 profit + the $57 in dividend payments upcoming for a total gain of $72.  So assuming commissions on the whole thing are less than $72 it would make sense to call the stock from you.  If the price was to move up in the interim all the more reason to do so.  You are only protected really if the price stays roughly constant and it's not worth the cost and effort to do it, or the price goes down.  The perfect situation for this type of strategy would be to buy them on a huge sell off and wait for the market to move up and then sell the calls and at least build yourself a little cushion.  This is one of those things that tend to fall into the "free lunch" category.  They sound great, but the chances of being able to capture the dividend for 2 years with virtually no real chance of any loss is somewhat slim.

[Ross812]

It seems as the call nears expiration the chance of the option being exercised increases. For a 1 or two year leap though, it doesn't make much sense for someone to call the option for a dividend... If I was the buyer of the 2014 $35 dollar JNJ call option for $28, I assume all the risk of purchasing JNJ at $63 and intend to hold JNJ for its capital appreciation between the present and 2014. If the march dividend is 0.57 and I exercise my option early at say $63 (any price it doesn't really matter) the stock goes ex dividend and loses 0.57 so I really don't make any money unless the stock price appreciates. I understand why the option would be called if it expires near the ex-date but the buyers if DITM calls are looking for capital appreciation.

 

I own DITM calls on MSFT, HPQ, JNJ, and INTC and would not exercise the leap to collect a dividend...   

[Ross812]

Has anyone ever tried this strategy before? Do those of you who hold DITM leaps exercise them to collect the dividend then buy another leap?