The Covered Calls Advisor's Dividend Capture Strategy

As Covered Calls investors, we buy stocks and sell Call options against the shares we own.  So first, good stock selection is critically important to our investing success.  In short, we should only establish Covered Calls positions in companies that we are Bullish on -- that we believe will appreciate in value over time.  I often say the "Stock Selection is Job #1" for the Covered Calls investor.  Second, we receive Call options premium income when we sell Call options against the shares we own.  As option sellers, we can often benefit (i.e. profit) from a decline in time value as our Covered Calls position progresses toward its options expiration date.  But there is an important third potential source of income for us Covered Calls investors, namely dividends.    

Dividends have the potential to provide a significant source of income for our stock portfolios.  Since the S&P 500 was established in 1926, capital appreciation has, on average, contributed 68% of the total return achieved by the S&P 500.  Dividend income has contributed the other 32%.  An alternate way of thinking about this is that of the average annual return of +7.0% over the years, +4.5% was from capital appreciation and +2.2% came from dividends.  

Since dividend income represents almost one-third of stocks total return potential over time, I wanted to develop a way to explicitly consider capturing dividend income as part of our Covered Calls investing process.  So, let's consider these concepts that will help us determine what specific criteria we should use in developing a Covered Calls "Dividend Capture Strategy":  

1. We prefer out-of-the-money strike prices when our Overall Market Meter sentiment is Bullish or Slightly Bullish, near-the-money when Neutral, and in-the-money when Bearish or Slightly Bearish.

2. Since dividends reduce the stock price by the amount of the dividend at market open on the ex-dividend date (remember: "there's no such thing as a free lunch in investing"), Covered Calls with in-the-money strike prices provide the best opportunity to both capture the dividend on the ex-dividend date but also to be in-the-money and therefore be assigned on the options expiration date.  So, we will normally obtain our best advantage using a "Dividend Capture Strategy" when we establish in-the-money Covered Calls positions (which would be when our market sentiment is either Slightly Bearish, Bearish, or even sometimes when Neutral).

3. We prefer short-duration (one month or less) Covered Calls positions since they provide higher potential annualized-return-on-investment (aroi) results than Covered Call positions of longer durations. 

4. For any company that we are Bullish on and would consider investing in, and which is also a dividend-paying company, we prefer to be invested in that company on its ex-dividend date (so we will capture the dividend).     

5. Most companies pay quarterly dividends, so we prefer to establish positions during the one month each quarter when that particular company goes ex-dividend.  Conversely, we can decide to avoid positions in that same company during the two months each quarter when they don't go ex-dividend--and instead switch our cash to other companies that do go ex-dividend in those months.  When we hold a position for a month or less and also capture its quarterly dividend, we effectively increase its equivalent-annualized-dividend-yield since the quarterly dividend income received is not spread over the entire 3 month period but rather is received only over the total number of days we hold the position during its ex-dividend month.

6. On the one hand, Call options owners will almost always consider exercising their Calls on the final business day prior to the ex-dividend date (to purchase the stock in order to capture the following day's dividend) and they will normally do so only when the stock price is deep-in-the-money such that the time value remaining then in the Calls is close to $0.00.  

7. For Covered Calls with intervening ex-dividend dates (i.e. ex-dividends prior to the options expiration date) we can evaluate the potential annualized-return-on-investment (aroi) before we enter our Covered Calls order under two scenarios: (1) if it is assigned early (on the day prior to the ex-dividend date); or (2) if it is assigned on the options expiration date.  To avoid being disappointed when we are assigned early and we therefore miss out on the dividend, we prefer that the aroi for early assignment is greater than the aroi if we capture the dividend and the position is instead assigned on the options expiration date.  Fortunately, we can calculate the potential aroi if assigned under both of these scenarios before we enter any Covered Calls order and we can choose to establish the position on days that achieve this desirable objective.  

8. We like to avoid the stock price volatility that normally occurs when quarterly earnings reports are released.  So before establishing a new Covered Calls position, we should always check for the the next earnings reporting date and avoid positions in companies with earnings reports prior to the potential options expiration date.   

Over several years, I have developed a list of rules to use prior to establishing a Covered Calls position with a dividend-paying company.  I have continued to modify the list to a point now that I believe this list of nine criteria (my "Dividend Capture Strategy") provides a solid framework for achieving market-beating results when applying the Covered Calls investing strategy to dividend-paying companies.  Here is an example of the application of these nine criteria to a recent Covered Calls position in CVS Health (see detailed blog post here):

In this CVS example for criteria #8 and #9 above, you can see how the annualized-return-on-investment potential for early assignment of +45.4% is greater than the +36.8% aroi if assigned on the options expiration date.  So, as stated in concept #7 in the article above, "To avoid being disappointed when we are assigned early and we therefore miss out on the dividend, we prefer the at aroi for early assignment is greater than the aroi if we capture the dividend and the position is instead assigned on the options expiration date."  

Many of the concepts described above are included as part of a more comprehensive blog post I made in 2021 that identified twelve "Investing Edges" we can exploit as Covered Calls investors that enable us to outperform typical stock market benchmarks (such as the S&P 500).  I encourage you to undertake a careful reading of this article when you have time to devote to it: Exploiting Our Covered Calls Investing "Edges".

This post is more in-depth than most.  My hope is that it will be useful to you.  I apologize if it is written in a way that is not as clear as it could be; so please feel free to email me at partlow@cox.net if I can clarify something that you have further question(s) about.  Replying to your questions will help me edit this post further in order to improve its completeness and clarity.

Best Wishes and Godspeed,
Jeff Partlow  
The Covered Calls Advisor

Stick With Covered Calls

I posted an article on this blog in 2009 that identifies four common alternative investing strategies to Covered Calls.  The article explains why throughout my investing career I decided to "Stick With Covered Calls".  

You can read it here.

Early Exercise of Call Options on the Day Prior to Ex-Dividend Date

Question: Can we predict whether our short Call Options will (or will not) be exercised on the day prior to the ex-dividend date? 

This morning, the Covered Calls Advisor was expecting to learn that my 3 short Cabot Oil & Gas August 20th $15.50 Calls had been exercised early on the day prior to today's ex-dividend date.  However, exercise of these Call options did NOT occur despite there being only $.02 time value remaining.  If the owner of the Calls had exercised, they would have collected today's ex-dividend at $.11 per share with only 11 days remaining until the options expiration date and the stock price currently 5.7% in-the-money.  

Today's surprising outcome was the opposite of five instances earlier this year (see chart below) when the opposite decision occurred, namely when the Covered Calls Advisor was surprised that early assignment DID occur given the relatively small ex-dividend amount minus time value remaining per day until expiration that the Call owners achieved by exercising early.  These early assignments always occurred on the day prior to the ex-dividend date and the Covered Calls Advisor was pleased to immediately receive the remaining time value as profit since the result of closing the Covered Calls positions early meant that a higher annualized return-on-investment (aroi) occurred (compared with the aroi that would be achieved if the position had instead been assigned later on the options expiration date).        

The higher the value in column 9 above, the greater the likelihood that the short Call options will be exercised early (on the day prior to the ex-dividend date).  However, in each case above, the Call owners' early exercise decisions were opposite of what the Covered Calls Advisor expected.  So, although we can often correctly guess whether our in-the-money Covered Calls positions will be assigned early (on the last business day prior to an ex-dividend date), these examples (experienced this year in the Covered Calls Advisor Portfolio) demonstrate that sometimes a Call owners' decision on the day prior to the ex-dividend date surprises us and is the opposite of what was expected.

As always, I welcome receiving your emails whenever you have any comments or questions related to this post or anything related to Covered Calls investing.

Jeff Partlow
Covered Calls Advisor
partlow@cox.net

 

Exploiting Our Covered Calls Investing "Edges"

For any given investing strategy, the investor should try to identify any and all discernible advantages that particular strategy has when compared against a basic Buy-and-Hold stocks approach.  In this regard, consider this investing wisdom from renowned investor Seth Klarman: "We believe that while investors need to focus great attention on the fundamentals, they must simultaneously answer the question: What's your edge? To succeed in today's overcrowded environment, investors need an edge, an advantage over the competition, to help them allocate their scarce time. Since most everyone has access to complete and accurate databases, powerful computers, and well-trained analytical talent, these resources provide less and less of a competitive edge; they are necessary but not sufficient. You cannot have an edge doing what everyone else is doing; to add value you must stand apart from the crowd. And when you do, you benefit from watching the competition at work." 

Identifying and then establishing a disciplined investing process to exploit these "edges" is what enables us to attain additional profit beyond that which would otherwise be obtained through a passive Buy-and-Hold stocks strategy.  So what are our "edges" as Covered Calls investors?  It is this advisor's belief that there are twelve edges, each of which can contribute to our opportunity to achieve excess returns:

1. Specialize in Covered Calls Investing -- Here is the introduction to one of my prior blog posts: "One of the most important investing lessons I've learned is to select an investing strategy that you are most comfortable with and stay with it. That is, do not try to be "a jack-of-all-trades and a master of none." Instead, try to continually increase your knowledge related to the strategy you are using and seek to become an expert at it." This fundamental belief in combination with the performance results achieved is what has sustained my commitment to Covered Calls investing during the past three decades -- thus this Covered Calls Advisor's investing motto of "Stick with Covered Calls."

2. Active Management -- The typical Buy-and-Hold investing strategy is a passive investing approach since stocks, mutual funds, and ETFs are normally purchased and held for a period of years. Likewise, Covered Calls investing can also be deployed passively, and passive Covered Calls-related indices (for example BXM, BXY, and PUT) have been developed. Research has shown that the long-term returns performance of these indices are approximately equivalent to that of a comparable buy-and-hold investment but with approximately 30% less risk. But as individual investors, we have the opportunity to be "active" (contrasted with "passive") managers of our Covered Calls portfolios. As active managers, an associated "edge" comes from deploying the strategies itemized in the additional items enumerated in the remainder of this article.

3. Stock Selection -- Stocks are an appreciating asset over prolonged time periods and historically have achieved a higher return-on-investment than buying other asset classes (bonds, real estate, commodities, stock options, etc.).  So, buying stocks should be the foundation of any long-term investing strategy, and buying stocks is fundamental to the Covered Calls strategy--where we buy stocks and sell Call options against the stocks we own.  Identifying and buying good stocks is Job #1 for the Covered Calls investor. Unlike broad-based indices, such as the S&P 500 ETF (SPY) or other ETFs (such as the sector ETFs), we seek to purchase value-oriented individual equities which are likely to continue in the future, as they have historically, to outperform broad-based indices.

4. Adjust Moneyness of Strike Prices -- As active Covered Calls investors, we have the flexibility to sell out-of-the-money Covered Calls when our outlook is more bullish and in-the-money when bearish, whereas the mechanical indices sell the same moneyness every month (for example, only at-the-money calls in the case of BXM). With even modest success at adjusting moneyness to coincide with (1) our overall market outlook, and (2) our personal risk tolerance, incrementally higher return-on-investment results are achieved.

5. Sell Higher-Than-Average Volatility -- Because of the large cap nature and the diversification inherent in the S&P 500 index, its Volatility Index (VIX) is lower than the overwhelming majority of individual stocks that comprise the index. Selling options on individual equities (with higher Implied Volatility than VIX) provides Covered Calls investors with higher options income (and thus somewhat higher overall portfolio returns) than would be achieved by either (1) buy-and-hold investing directly in the S&P 500; or (2) selling S&P 500 options (such as is done with the BXM, BXY, and PUT indices).  

In addition, we can benefit from the knowledge that the Implied Volatility of a stock has an inverse relationship with its short-term stock price.  That is, Implied Volatility (and therefore also the annualized-return-on-investment (aroi) potential) decreases as a stock's price increases (and becomes overbought).  Conversely, Implied Volatility (and aroi) increases somewhat when short-term stock prices decline and become oversold, often making this an opportune time to establish new Covered Calls positions--but of course only in companies we are bullish on (see item #3 on Stock Selection above). 

6. Exploiting the Volatility Risk Premium -- Academic research has demonstrated that the Implied Volatility of option prices is, on average, higher their subsequent actual realized volatility. Thus, by selling options to establish our Covered Calls positions (NOT buying options), we Covered Calls investors exploit this effect (another "edge" versus buy-and-hold investors) and profit from it.

7. Increase Frequency of Trading -- The time value decay of options increases the closer they get to their expiration date.  So, shorter duration Covered Calls positions provide a higher potential annualized-return-on-investment than their longer duration counterparts.  Favoring monthly, bi-weekly, or even weekly Covered Calls is preferable to positions of longer duration (two months, three months, or longer).  An added benefit of shorter-dated options is that they provide more frequent opportunities to re-evaluate our holdings and to modify our ongoing strike prices given the ever-changing nature of market prices and individual stock outlooks.  

8. Adjust Our Position Sizing -- We can use the Greek value of Delta as a good approximation of the probability of assignment of any Covered Calls position we are considering prior to entering the position.  Delta values enable us also approximate an Expected Value for the Annualized Return-on-Investment potential for various stock price outcomes on the options expiration date (such as if the stock price is unchanged, or if the stock price ends in-the-money).  This knowledge of various Expected Value Return-on-Investment outcomes helps us to determine the position sizing for the investment -- higher Expected Value Returns corresponding to larger-than-average total dollar positions and lower Expected Value Returns corresponding to below-average total dollar positions.

9. Seek to Minimize Losses -- Because our compounded return-on-investment results over time are geometric returns (not average returns), losses are difficult to overcome.  For example, a 33 1/3% loss doesn't require a 33 1/3% gain to get back to breakeven; it requires a 50% gain (and a 50% loss would require a 100% gain).  Covered Calls provide an advantage over the traditional buy-and-hold stocks in this regard since selling Call options against our stock holdings provides a hedge (i.e. lowers our stock downside breakeven price point) and therefore increases the likelihood that we will be profitable on our positions.  Furthermore, when we are selecting a strike price for any position where we have doubt between two potential strikes, we can select the more conservative (i.e. lower) strike price to decrease our probability of losing money on the position, therefore further increasing our probability of achieving a profitable outcome.

10. Invest in Non-Correlated Assets -- Another way (in addition to that stated in #9 above) we can minimize drawdowns (i.e. losses) in our portfolio is to seek to diversify our portfolio via non-correlated assets.  We know intuitively and from our own investing experience that different asset classes rotate in-and-out of favor and that it is extremely difficult to try to predict when these rotations will occur.  But there is substantial academic research that has determined that investing in non-correlated assets (such as by asset classes, sectors, industries, geographies, etc.) enhances geometric returns.  So, achieving adequate diversification via non-correlated assets in our portfolios is another important consideration.  

11. Use a Tax-Advantaged IRA Account -- The great likelihood of triggering short-term capital gains makes Covered Calls an ideal strategy for either Traditional and/or Roth IRAs since these gains can either be taken as current year distributions (taxable) or left in the IRA (tax-free) for additional future investments growth.

12. Use a Dividend Capture Strategy When Appropriate -- Covered Calls investors can increase the annual dividend yield of quarterly dividend-paying companies by establishing Covered Calls positions during the single month each quarter when they go ex-dividend (and avoiding those same companies during the other two months each quarter when no dividend is paid).  The Covered Calls Advisor's "Dividend Capture Strategy Worksheet" was designed to identify these opportunities that provide another "edge" to our financial results.  These positions can be especially attractive to boost returns in low-growth and/or below average Implied Volatility sectors (like the Consumer Staples, Energy, Financials, Industrials, Materials, Real Estate, and Utilities sectors).       

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From my experience, my best estimate is that over a long-term investing horizon (say 10+ years), a disciplined Covered Calls investor that is cognizant of the twelve "edges" described above, and works to take advantage of them might expect (on average over the years), to outperform a buy-and-hold benchmark (such as the S&P 500) by at least 3 to 5 percentage points on an annualized-return-on-investment basis. This extra return might not sound especially impressive, but the power of compounding investment returns is substantial. Suppose that over the next decade a Buy-and-Hold S&P 500 investor averages an 8% annualized return; and a Covered Calls investor averages a 12% return. Then, an initial $100,000 portfolio would grow (excluding taxes) over the next 10 years, to about $215,900 for a buy-and-hold portfolio; but to $310,600 for the Covered Calls portfolio. Whereas individually, each of these "edges" described above provides only a small advantage, together they can provide a very significant advantage for informed and disciplined Covered Calls investors.
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More detailed information on Covered Calls investing can be found on the author's free blog site, http://coveredcallsadvisor.blogspot.com/

Covered Calls in IRA Accounts

I am not a CPA, Enrolled Agent, or Tax Attorney -- so I don't give tax advice. Nevertheless, as an informed investor and self-proclaimed Covered Calls Advisor, I want to be sure you are aware of the benefits of Covered Calls investing in IRA accounts.  This article from Investopedia.com (see here) briefly summarizes these advantages as follows:

IRA Advantages -- The possibility of triggering a possible reportable capital gain makes covered call writing an ideal strategy for either a traditional or Roth IRA.  This allows the investor to buy back the stock at an appropriate price without having to worry about tax consequences, as well as generate additional income that can either be taken as distributions or reinvested.

For more detailed information on the tax implications of Covered Calls, I have found this article from Fidelity to be the most informative -- please read it here.

My wife and I are retired and have several IRA accounts (Traditional, Roth, and Rollover IRAs) as well as a brokerage account.  We prioritize by investing only via Covered Calls in our IRAs and we re-invest our capital gains there into additional Covered Calls positions.  We are fortunate that we will only need to begin taking annual taxable withdrawals from our Traditional and Rollover IRAs starting at age 72 when the current tax laws related to Required Minimum Distributions (RMDs) kicks in.  (Note: if we take any future withdrawals from our Roth IRAs that will be non-taxable income).  Finally, regarding our brokerage account, we also do some Covered Calls investing there and pay taxes on our realized capital gains each year.  The bookkeeping is simplified substantially since we have our broker (Schwab) download all our brokerage account transaction details into TurboTax.  

Best Wishes and Godspeed,
Jeff
partlow@cox.net

Spreadsheet for Evaluating Possible Dividend Capture Covered Calls

Below is an Excel spreadsheet format developed specifically to estimate potential annualized return-on-investments for Covered Calls with companies having good investment potential and with ex-dividend dates prior to the options expiration dates.  I thought I would share this since some of you might want to use a similar spreadsheet format.  

I did this spreadsheet this morning during pre-market hours (i.e. before the market opened).  For each company, I look at some different expiration dates and strike prices before selecting my preferred combination and entering it on the spreadsheet.  In my case, I'm looking for positions that would most likely meet the criteria I've developed for my Dividend Capture Strategy.  

After market open this morning, I made a decision to enter buy/write limit orders for LNC and NTAP, but neither one executed today.  That's okay with me since I almost always enter Covered Calls limit orders at the net debit price that I would like to pay.  Sometimes they execute and sometimes they don't -- and that's fine with me.  

 

Stock Selection Example for a Potential Covered Calls Position

I thought you might be interested in an example of how I identified and researched a company this weekend as a potential candidate as a Covered Calls investment.  That company turned out to be Hologic Inc.

Step 1: Of the 3,500+ stocks with options, how do we narrow it down to a manageable number of companies to consider?  For me, I've found online stock screeners (available free from your broker or by subscription from investment services) to be a good tool to do this.

Step 2: Over the past several years, I've developed numerous screeners which are customized for different purposes.  For example, the one I used here is a "Large-Cap Value, Profitability, and Growth" screener.  I won't get overly detailed now by describing the nine metrics used in this particular screener, but the companies identified by it were: Rio Tinto Inc., HCA Healthcare, Laboratory Corp., Hologic, Inc., Pulte Home Group, McKesson Corp., NVR Inc., Anthem Inc., and Lockheed Martin.  By the way, only 9 stocks from this screen is the lowest number I can remember.  With the market at all-time highs, it seems like it is now more difficult to find good undervalued companies to invest in.

Step 3: As you might recall, I already have a current position in Rio Tinto (see link).  Looking at the numbers for these 9 companies and then reading further about each one, my interest narrowed further to Hologic, Anthem, and Pulte.  During the past several months, I had already done detailed research on both Anthem and Pulte (and had successful positions in both of them), so I decided to research Hologic in more detail using my Options and Company Checklist:   

 

Step 4: Make a decision.  Hologic seems like a great candidate for a Covered Calls position, but my one remaining question is the extent to which Hologic's dramatic increase in revenue as a result of the dramatic increase in Covid assays performed by their Panther machines during the past year will decrease during the upcoming year and the impact of that on this year's revenue and earnings.  I will see if I can find existing comments from Hologic's CEO or CFO and also from any other resources on this question.  If I can get a good answer to this question and I like what I learn, then I'll establish a Covered Calls position and of course will post it on this blog site on the same day the position is established.  If not, I'll be satisfied to have learned a lot about the company and it would remain on my radar to consider as a possible future investment.

 

Step 5: After making a decision on Hologic, then proceed to further reading, research, and thinking in search for other potential Covered Calls investment opportunities.  Remember, "Good stock selection is Job #1 for us Covered Calls investors".

 

Hope you found something interesting and useful in this post.  As always, please email me with any questions.

 

Best Wishes and Godspeed,

Jeff Partlow
partlow@cox.net

Answers to Quiz #3

I am pleased that twenty-four responses were received to Quiz #3. Everyone had six or more correct answers and four responses were 100% correct. All ten questions were developed from information contained in the first two sections of my favorite book primarily about Covered Calls: "New Insights on Covered Call Writing" by Lehman and McMillan. If you don't already have it, please consider reading it carefully. One place you can get it is here: https://rb.gy/tzahq0

1. Another name for Covered Calls is any one of three answers were possible here: Buy-Write, Covered Write, or Equity Overwrite.

2. Each Call option represents how many shares? _100____

3. The Call owner has the right to buy. The Call seller has the _obligation to sell.

4. When the Call owner exercises their Call option, the Call seller must be assigned (sell) the shares at the strike price_.

5. You established a Covered Call by buying 100 shares of XYZ at $102 and sold a $100 Call option at $4 premium. The net profit if assigned at expiration (excluding commissions) is $_$200 ($2 per share profit x 100 shares)_.

6. If you make a $200 net profit on a $10,000 investment in exactly one month, your annualized return-on-investment is _24%_.

7. The closer to the options expiration date we get, the rate of an option's time value decay increases.

8. To roll out a current Covered Calls position to a future Covered Calls in the same stock, a single  buy-to-close current Calls and sell-to-open future Calls transaction is made.
There was some confusion on what I was asking for here, so I also gave credit to answers such as rollout or rolling.

9. An out-of-the-money Call option has only time value (also known as extrinsic value).

10. Before entering a Covered Calls position on stock XYZ, the best way to compare potential financial results in positions with differing expiration dates is by calculating their annualized return on investment.

Some of the questions on these 3 quizzes have been related to obtaining a better understanding of certain terms related to Covered Calls. I suggest you try searching via Investopedia.com whenever you seek further insight on any specific investing-related term or topic.

As you know, these quizzes are intended only for the purpose of providing information and education for anyone interested in Covered Calls investing. Hopefully, these quizzes have helped you in some way and have encouraged you to want to learn more about Covered Calls investing.  As always, I enjoy receiving your questions or comments about anything related to Covered Calls investing -- at partlow@cox.net

Best Wishes and Stay Safe,
Jeff

Pop Quiz #3

Pop Quiz #1 had a narrative list question and Pop Quiz #2 had six multiple choice questions.
So, to continue with a variety of quiz types, Pop Quiz #3 below has ten fill-in-the-blank questions.

I will post my answers to each of these on Wednesday this week.

In the mean time, please email me at partlow@cox.net with your answers and I will send you a reply with the correct answers.

1. Another name for Covered Calls is ___________________.

2. Each Call option represents how many shares? _______

3. The Call owner has the right to buy. The Call seller has the ____________ to sell.

4. When the Call owner exercises their Call option, the Call seller must ___________________.

5. You established a Covered Call by buying 100 share of XYZ at $102 and sold a $100 Call option at $4 premium. The net profit if assigned at expiration (excluding commissions) is $_______.

6. If you make a $200 net profit on a $10,000 investment in exactly one month, your annualized return-on-investment is ______%.

7. The closer to the options expiration date we get, the rate of an option's time value decay (increases, decreases, or stays the same)?

8. To roll out a current Covered Calls position to a future Covered Calls in the same stock, a single ____________ transaction is made.

9. An out-of-the-money Call option has only __________ value.

10. Before entering a Covered Calls position on stock XYZ, the best way to compare potential financial results in positions with differing expiration dates is by calculating their ____________________________.

Best Wishes,
Jeff

Answers to Pop Quiz #2

To my fellow Covered Calls investors,
Below are my answers and explanations regarding the six questions in Pop Quiz #2: Link to Post with Pop Quiz #2 Questions

Question #1. Covered Calls are best described as:
A. A stock investing strategy
B. An options strategy
C. A stock hedging strategy
D. A spread strategy
E. None of the Above

The correct answer is C:  Covered Calls are best described as a stock hedging strategy.

Only 4 of 27 responses answered correctly.
The most popular answer (17 of 27 responses) was: Covered Calls are best described as an options strategy.

I have been investing via Covered Calls since the late 1970s, but it wasn’t until I read “Option Volatility and Pricing” by Sheldon Natenberg in the mid-1990s that it became clear to me that Covered Calls positions are essentially a stock hedging strategy.  Naternberg's book is one of the most widely read books among active option traders around the world.  His discussion of Covered Calls is contained in the chapter titled “Hedging with Options”.  I have always, and still to this day, consider myself to be a “Covered Calls investor”, but Natenberg refers to us as “hedgers”.  

A definition of hedging is when you take a position to protect against losses in some other position.  So, we take a position (think of us selling Call options on stock XYZ) to protect against losses in another position (think us owning shares of stock XYZ).    I consider the best book written primarily about Covered Calls investing is “New Insights on Covered Call Writing” by Lehman and McMillan (if you don't already have it in your personal library you can get it here).  In Chapter 4: "Turning a Position into a Strategy”, there is a section titled “Hedging Individual Stocks”.  The first sentence says: “When you write a call against a stock position, you are reducing the downside risk of the stock position by the amount of premium you take in.”   Therefore, establishing a Covered Calls position essentially enables us to reduce our initial cost basis in buying the stock by the amount of the Call options premium we receive from selling those options.

Now, regarding the most popular answer (17 of 26 responses) that Covered Calls are best described as an options strategy.

Yes, Call options are one of the two components of a Covered Calls position.  However, the position includes both stocks and options and the Call options are used primarily to provide some downside protection (a “hedge”) to our long stock position; that is, some profit protection even if a small decline in the stock purchase price occurs.  So, considering the role of both components of Covered Calls positions together, the most complete answer is that “Covered Calls are best described as  a stock hedging strategy”.  

Question #2. Covered Calls return-on-investment results are:
A. Better than a stocks buy-and-hold portfolio
B. Worse than a stocks buy-and-hold portfolio
C. About the same as a stocks buy-and-hold portfolio
D. None of the Above

I decided that a reasonable case could be made for all of these answers, so I considered all of your answers correct on this one.  There was at least one person that chose each of the four possible answers, but I was very pleased to see that 22 of you chose A.

The introduction to my Covered Calls Advisor blog states: “The goal of this blog is to share information helpful to all who are interested in Covered Calls. It will demonstrate that by following an informed and disciplined process, Covered Calls investing achieves market-beating returns.”   So although my own experience affirms my belief that Covered Calls do achieve market-beating returns, it is also heartening to see that so many of you agree.  However, answer D is also appealing to me because I know that market-beating returns are not guaranteed.  There are Covered Calls investors that experience answer C and unfortunately also answer B (for a variety of reasons, but most frequently because of poor stock selection).

Question #3. Covered Calls are _____________ than buying-and-holding stocks.
A. more risky
B. less risky
C. about the same risk
D. None of the Above

The correct answer is B:  Covered Calls are less risky than buying-and-holding stocks.

20 of the 27 responses answered correctly.

Several academic studies have concluded that Covered Calls portfolios are, on average, about 30% less risky than comparable buy-and-hold stocks portfolios.  These studies are very technical and are often authored by experts in advanced mathematics and statistics.  I have been unsuccessful in understanding all aspects of these papers, but my common sense informs me that their results are reasonable.

Question #4. The largest time value in a Call option occurs:
A. at-the-money
B. in-the-money
C. out-of-the money
D. None of the Above

The correct answer is A: The largest time value in a Call option occurs at-the-money.

There were 16 correct answers to this question. 

I thought a good way to show the answer would be to show a real-time example.
The green circles on the SPY options chain screen below show that the largest time value (also known as the extrinsic value) for both Calls and Puts occurs at the nearest-to-the-money strike price (in this case at the $337.00 strike price when SPY was trading at $337.04).

Extra Credit Question to think about: Given the options principle of Put/Call Parity, why do you think the time value in this example of $8.15 for the Puts is greater than the $7.54 for the Calls?

Question #5. The most likely time for a Covered Calls position to be assigned early is:
A. Anytime the option is in-the-money
B. When the stock increases from the purchase price
C. The day before the options expiration date
D. The day before the stock ex-dividend date
E. None of the above

The correct answer is D: The most likely time for a Covered Calls position to be assigned early is the day before the stock ex-dividend date.

There were 16 correct answers to this question.

An excellent explanation of why this is true is provided in a 2012 article in the Born-to-Sell blog:
Read at link here.

Question #6. When Cash-Secured Puts are transacted at the same time, at the same strike price, at the same expiration date, and for the same stock as Covered Calls, they are:
A. The same as Naked Covered Calls
B. The opposite of Covered Calls
C. Almost Equivalent to Covered Calls
D. More Risky than Covered Calls
E. More Conservative than Covered Calls
F. None of the Above

The correct answer is C:  When Cash-Secured Puts are transacted at the same time, at the same strike price, at the same expiration date, and for the same stock as Covered Calls, they are almost equivalent to Covered Calls.

There were 12 correct answers to this question.

This is an important concept to understand, so please commit the time necessary to carefully read (and re-read if necessary) these two blog articles. Each article addresses the close equivalence of Covered Calls and Cash-Secured Puts:

https://optionparty.com/cash-secured-puts-vs-covered-calls/

https://coveredcallsadvisor.blogspot.com/2009/05/covered-calls-versus-cash-secured-puts.html

Bonus Question -- Take a Guess: What percentage of respondents will get all six questions correct?

The answer is 0%


I hope your knowledge (and curiosity to continue learning) about Covered Calls investing is increasing from these Pop Quizzes.  I am pleased that 27 people responded to this 2nd quiz.  This response encourages me to consider the possibility of creating Quiz #3 before the end of this month.
Hint: There will be at least 2 questions developed from the information written above in the answers to these six questions included in Pop Quiz #3.

Best Wishes and Godspeed,
Jeff