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Jonathan is a member of The Motley Fool Blog Network — entries represent the personal opinions of our bloggers and are not formally edited.
While reading romance novels or action thrillers at the beach, writing covered call options on Big Oil companies such as Occidental Petroleum (NYSE: OXY), Chevron Corporation (NYSE: CVX) and Exxon Mobil (NYSE: XOM) could be a profitable way for investors to spend their summer vacations.
Option Mechanics
Writing covered call options entails selling the right to buy shares of a stock you own within a set period of time. This is transacted through a call option of which the option buyer has the right to buy the underlying stock of the contract at a set price. On the flip side, the option writer has the obligation to sell the underlying stock at the contract price upon exercise from the option buyer.
As an example, if you own Chevron Corporation at $100 a share and write a covered call option to sell shares at $105 each, you will be paid the premium by the purchaser of the call option. If Chevron goes over $105, the call option will be exercised by the buyer and your shares sold. All of your holdings of a stock such as Occidental Petroleum or Exxon Mobil do not have to be sold, only the portion that you have decided to put on the market, assuming that you hold more shares than you have written options against. This allows for shares to be retained as a hedge.
There are three factors that make writing covered call options especially attractive for Exxon Mobil, Occidental Petroleum an Chevron Corporation. Each is down in price and likely to remain so for some time due to global oil usage being down and worldwide inventory levels high. The exchange traded fund for oil, United States Oil (AMEX: USO), is off 13.60% for the last month of market action, as an example of the adverse supply and demand situation. It is likely to fall even more, as will the share prices of Occidental Petroleum, Exxon Mobil and Chevron Corporation. Thus writing covered call options can generate income in bearish market conditions.
The second factor is the each oil company pays a healthy dividend. Even though a call option has been sold, the owner of the shares, not the option, receives the dividend income. This provides the best of both worlds to the shareholder: selling an option to sell if the stock rises to a selected price while still receiving dividend checks in the mail.
Thirdly, most options are not exercised. More than three-quarters go unexercised. That allows for the writer of the covered call options to generate another source of income even if the stock falls in price.
Writing covered call options allows for income to be generated in three manners. The first is from the actual writing of the call option. The owner of the stock is paid a premium by the buyer of the call option. That is obviously priced by the market, depending on variables such as length of time and share price, among others.
The next way income is produced is that capital gains are earned if the stock is sold at a price higher than the purchase level. Suppose Chevron had been bought at $85 a share back in October 2011 and you now want to book profits and redeploy funds elsewhere.
As Chevron is presently trading around $96.80, you might want to write a covered call option to sell at $100, hoping that news of globl economic growth or trouble in the Mideast takes it higher. If the sale of the call option for Chevron executes at $100, then $15 in capital gains, the premium for the sale of the covered call option, and dividend income for that span would be booked as gains.
The dividend income is important not only for Big Oil, but the total gains of all stocks. John Neff, the legendary founder of the Vanguard mutual funds family, wrote in his book “Enough” that dividend income has, historically, been about 45% of the total returns for equities. That is significant as Occidental Petroleum now yields 2.61%. The average dividend for a stock on the Standard Poor’s 500 Index is around 2%. Chevron is almost double that with a 3.59% dividend of $3.60 a year. Exxon Mobil recently raised its dividend to 2.78%.
Three things can happen after a covered call option is written. All result in gains for the shareholder. As about 80% of options are not exercised, the most likely outcome may be that Chevron, bought at $85 and now trading for under $97, does not move past $100 and is retained while earning both the premium income and the dividend income. The next scenario is that Chevron continues to decline, which results in both the premium income and dividend income being booked. The third is that Chevron rises above the $100 call price, which is then exercised. From this, the writer of the covered call option in our example registers capital gains of $15 a share on the shares written and sold, the rise in the share price on any remaining shares, the initial premuim income, and the $3.60 annual dividend for Chevron for that period of the year.
Exxon Mobil, Occidental Petroleum and Chevron Corporation are very solid companies that will rise again when global oil usage rebounds. Unrest in The Middle East could also send the price of crude spiraling higher even sooner. Writing covered call options on dividend-paying oil companies such as Chevron Corporation, Exxon Mobil and Occidental Petroleum allow for investors to earn income while waiting for the share price to recover. Best of all, it can be done over and over again to constantly generate the additional income streams.