Call Options Strategies For Dividend Investing

Call options usually do not interest dividend investors because options holders are not entitled to dividends.

That doesn’t mean dividend investors have no use for calls.

Calls have utility for dividend investors because we can actually use the time decay characteristics to our advantage by selling call options contracts.

Before we go on I’ll mention that options pricing is very complex and there are many options trading strategies. You can fill your bookshelf with books on options. I’ll just talk about the aspects germane to dividend investors.

I won’t get in to complex topics like volatility trading, complex spreads or straddles, ratios, arbitrage, and so on because those types of strategies are not consistent with dividend investing.

Call Option Basics

A call option is a contract whereby the option buyer has the right to buy (or “call”) the stock for a pre-determined price (called the strike price) by an agreed upon time (called the options expiration date).

The option will be exercised (converted to shares) only if option is “in-the-money” meaning the stock’s price is higher than the strike price.

When the option is exercised, the investor who holds option will pay the strike price to receive the stock. The investor who sold the call options will be "assigned" meaning he'll need to sell the stocks for that price.

An “out-of-the-money” option, meaning the stock’s price is below the strike price, will expire worthless.

Example: Microsoft is trading for about $24.50 per share in July. You can buy a MSFT AUG 26 (read this as Microsoft with a strike price of $26 which expires in August) call option contract for $0.57. Since one option contract buys 100-shares, the option costs $57 plus commissions. This means you are paying $57 for the right to buy MSFT 100-shares for $26 per share, but this right expires in August (expiration is Saturday after the 3rd Friday of the month).

If MSFT closes above $26 by the expiration date in August you can exercise your option to buy the stock for $26 per share even though MSFT’s stock price is trading above that value. Your profit will be the difference between stock price and strike price, minus commissions and cost of the call option.

If MSFT’s price is below $26 at option expiration, your option expires worthless and you get nothing.

You can see the advantage in paying $57 for a call option if you think MSFT will rise in price.

If MSFT rises to $28 by the option expiration date, the options investing strategy results in a $200 profit on a $57 investment, as opposed to a $200 profit on the $2,450 invested to buy 100 shares. The gain for the option buyer is about 350%. The gain for the shareholder is 8%.

The risk is that the option buyer must be certain about his forecast. If MSFT does not rise above $26 by the option expiration date he ends up with nothing.

Additionally, the option holder does not receive dividends while a shareholder does.

Finding Call Option Data

The easiest way to find information about options investing is to go to Yahoo! Finance.

Type the name or ticker symbol of a stock that interests you.

Click on the link in the left column called "Options". If that link is not present then the stock does not trade options.

You can view the options by expiration date. Click the expiration date that interests you.

The options are listed by strike price. Calls are listed first, then puts.

The Ask price is what you will pay to buy an option. The Bid price is what you get if you want to sell an option.

You should pay attention to Open Interest which tells you how many of those particular options contracts are open right now. Volume tells you how many are being actively traded. You don't want to trade thinly traded options.

Selling Calls Can Be Very Profitable

The call buyer must be right on three things.

1. The direction of the market (up or down).
2. The magnitude of the move (how far the stock must move to go above the strike price).
3. The time that it will take for the market to move as far as he thinks it will move (the move must happen before the option contract expires).

Being wrong on any one of these three parameters means the option buyer will lose his option premium.

As you might guess call buyers typically lose money because being right on all three criteria is very hard to do.

The dividend investor who sells calls only has to be right on one of the three parameters.

The odds are in your favor.

As dividend investors we can use that as an opportunity to make additional income by employing two strategies.

One More Thing . . . Find The Right Broker

First time options traders will have to set up their brokerage account to handle options. It involves reading a pamphlet on options trading, and will probably require signing an options agreement.

If you are a first-time options trader the broker may restrict you to long options (options you buy) and covered calls.

The commissions charged for options trading vary greatly.

Some brokers' commissions are so high that you may have difficulty generating a profit from options trading.

Shop around.

Many online traders have reduced their commissions.

You shouldn't pay more than $10 per trade.

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