11/5/08

How I Might Get a 55% Dividend Yield On WFC

I wrote previously about using deep in the money covered calls to boost your dividend yield. Basically, when you do a buy write and use the lowest strike price possible, you end up purchasing shares of a stock for a fraction of their trading price. If those shares pay dividends, your yield is substantially higher than if you buy the shares without writing the call.

Commissions included (also accounting for the commission I'll incur when my Wells Fargo Shares will be called) I paid $2.70 a share for WFC. I bought shares of the stock near the close yesterday (11/4/08) for $34.93 while at the same time selling the Jan '10 LEAP at the 2.5 strike (WWR AK) for $32.98.

If my stock isn't called until the expiry date, and Wells Fargo continues paying quarterly dividends of $0.34 a share, I will receive a total of $1.70 a share in dividends. Since I'll get $2.50 when the stock is called, my net dividend gain will be $1.50. That's a yield over 55%, given my net debit is $2.70.

I wrote previously that such an enterprise is worthwhile only if your net debit is less than the strike price, so that if/when your shares are called, you don't lose any money. For example, if you buy for a net debit of $2.70 and the strike price is 2.5, you'll lose $0.20 a share if the stock is called. That's correct, but I'd like to offer an addendum. If you do the transaction as near as possible to the close of trading on the day before the ex-date, you minimize lessen but by no means eliminate the chances of being called that day. If you're called on the ex-date or after, you'll get the dividend, which just has to be greater than the difference between your net debit and the strike price to make the transaction worthwhile.

I couldn't get WFC for less than the strike, so I acted in the last minutes of trading yesterday. Today is ex-dividend day. If my shares are called, I'll get the dividend. As it's $0.34 a share, starting today I can't lose money if the shares are called. I can still lose money overall, but that's only if WFC stops paying dividends and its share price goes below $2.50.

[Update 12/31/08: I received my dividend in early December. I have a $0.14 a share gain, factoring in all past and maximum future expenses. I cannot lose money on this trade unless WFC stock goes below $2.5 per share.

In trying this strategy again, and corresponding with another person attempting to implement it, I discovered that these deep in the money calls are exercised in great frequency. (1) I was aware of the fact that calls are more likely to be exercised right before ex-dividend day, but didn't think that this was very likely with LEAPs at low strikes. Turns out that it is. (2) According to the CBOE, options holders have until 4:30 P.M. Central Time to exercise their rights. Even making the above mentioned trade at 3:59 P.M. Eastern Time does not eliminate one's assignment risk that day, as the option buyer potentially has another hour and a half to exercise the options. I guess I was lucky with WFC not being called away soon after I placed the trade.

I still can't figure out how the person on the other side of this trade is making money when he exercises his call, unless he's betting on the underlying stock's direction the next day. If he does it before ex-dividend day, he pays me the strike price * contracts * 100. In exchange, he receives the shares, which are then valued at market price, and he gets the dividend. So, basically, he's getting the dividend, say $0.30 a share in exchange for paying me the strike, say $2.50 a share. Net result here is that he's paying $2.20 in addition to what he already paid for the calls to get the shares. Whether he gains or loses depends on how the stock trades after he gets the shares. My question is, why bother with buying calls and then exercising them shortly thereafter on the same day? Why not just buy the shares? Why pay the extra commissions to wind up in the same place?

The person I've been corresponding with theorizes that these are not ordinary traders on the other side, but those that are part of the market machinery. I can see that, but we still wonder, is it really worth it for them to do that? How much money can they possibly make?

Update 1/3/09:

Here's a potential answer. (Note that the link is a Word file. It doesn't appear to have viruses, but be careful.)]

So why did I choose WFC? It has a 2.5 LEAP call strike and a dividend that appears safe for the moment. It'll be worthwhile even if the dividend is cut in half. Best case scenario, WFC continues paying dividends and I'm able to roll my calls for credits or small net debits. Then I can make around 50% a year on it indefinitely. This is unlikely. Second best scenario, I get called at the options expiration date. Worst case, WFC goes out of business and I lose my small net debit. This is not that likely. Second worst case, my shares are called before the next ex-dividend date, and I end up making around 5% for my trouble (0.14/2.70). Overall, I think it's a pretty good deal.

Update 2/22/09: I had all my shares called on February 4, 2009. I suspect that the owners of the calls exercised them on the 3rd. If that's the case, I've made 5% on my investment over four months. Not too shabby, but I hope I receive the next dividend payment.

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