This post is going to describe for you one of my favourite equity positions, the covered call. A well executed covered call position can be a cash-flow generating machine that increases the yield of a position by a complete handful of percentage points. Here’s how it works.
When an investor sells a call contract, they are selling the right to purchase a given equity at a set price. While this creates the risk of an obligation to sell out the position at an opportunity loss, or before the holder wanted to, it provides an immediate return for the investor in the form of a premium. The result is that the investor has hedged the sell-price of their position. With that understood, let me show you how we can apply this theory towards this week’s increasingly sophistically hypothetical investor.
As mentioned before, our investor it hoping to buy exposure to XYZ’s 10% dividend yield, but is concerned that the price of the stock will fall over the short term. Undeterred, the investor purchases 100 units of the stock, in order to hedge the down-side exposure. After doing some simple math, the investor’s advisor identifies an opportunity. The investor can sell a 12month call contract that allows the buyer to purchase the XYZ position from the investor at the same price that the investor paid to purchase it. In exchange, the investor receives a 5% premium.
This means that the investor has just earned an immediate 5% return on their position, which they will hold for the next 12 months. The investor will also maintain exposure to the dividend, meaning that they could earn as much as a 15% yield (as opposed to the normal 10%) on the equity if the contract is never executed.
However, if the value of the stock rises more than 5% at any point during the next year, the investor will likely see the contract executed, and will be forced to sell the position at a loss against opportunity costs. But who cares? The investor made an absolute return of at least 5%, and can re-enter the same position again to maintain their exposure to the dividend.
This kind of position once again demonstrates the value of a personal investor’s ability to assume time-value risk as opposed to cash-flow risk. By turning a risky position with capital gains implications into a hedged fixed-income asset, a personal investor can better plan their portfolio around their regular expenses, goals, and lifestyle, without having to put more money at risk.
So long as the investor is willing to spread out their returns over a greater period of time, is willing to cooperate with their advisor to do the proper due-diligence associated with crunching the numbers, and limit their returns to only meeting their reasonable returns, a patient investor can secure their dividends portfolio against even the nastiest of volatile environments. Don’t have time to crunch the numbers on how to best hedge your position? In my next article, I’ll show you a much easier way to gain covered-call exposure.
