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Over the past couple of weeks, we have been looking at covered call trades as a way to generate income and boost returns while actually decreasing the amount of risk that traditional investors take on. We've gone over the basic strategy of buying stock and selling calls, the difference between option strike prices, and some important factors for picking the right expiration month.
Today, I want to show you just how powerful this covered call writing strategy can be when combined with a stock that already pays a dividend. In this case, we're actually compounding the dividend yield of the stock to give us three times the traditional income that most investors would receive.
For today's example, we're going to use Darden Restaurants (NYSE: DRI), which is currently trading near $50.20. The company owns a number of popular restaurant brands including, Olive Garden, Longhorn Steakhouse, Bahama Breeze and Red Lobster.
On Friday, the company announced earnings that beat Wall Street forecasts. The stock traded higher based on the report, and from a technical perspective, DRI looks like it is breaking out of a solid base and has the potential to trade much higher.
Considering the positive developments on the employment and housing fronts, consumers are feeling more confident and willing to spend. This is great news for a company that relies on middle-class discretionary spending. Over the next few weeks, I expect DRI to rally into the mid-$50s, which gives us a nice opportunity to set up a covered call trade.
A 22% Annualized Return With an Outside Shot at 50%-Plus
Since Darden Restaurants is a strong, cash-flow-positive business, the company pays out a healthy dividend to its investors. Right now, the dividend yield is 4% with the company paying a $0.50 dividend every three months.
Of course, a 4% annualized gain isn't much to get excited about, but if we time our covered call trade correctly, we can use the dividend payment to set up a much more attractive situation.
Today, I want to buy DRI stock near its current price of $50.20, and sell the May $50 calls against the position. These calls were recently offered at $1.25 per share, so there is a significant amount of premium built into the option price.
Here is what our entry looks like:
• Buy DRI at $50.20 in 100-share lots• Sell one DRI May 50 Call at $1.25 for every 100 shares purchased• Our net cost per share is $48.95
The trade gets better when you factor in the extra yield. Darden Restaurants pays a quarterly dividend of $0.50. This payment is scheduled to be sent to shareholders of record on April 10. So if we own the stock at the close on April 10, we will receive a check for $0.50 for every share that we own. When we calculate our return, we need to include the dividend payment in the metrics.
If DRI continues to trade higher and closes above $50 when the May contracts expire, we will have an obligation to sell our stock at $50. This means that we recognize a $1.05 profit above our net cost of $48.95, along with the $0.50 dividend payment.
So our total gain for the trade will be $1.55, good for a 3.17% profit. The maximum amount of time for this trade is 52 days (the calls expire May 17). So if you annualize 3.17% over a 52-day period, that nets out to a 22% annualized return.
Of course, 22% isn't a bad annualized return, but it's not as high as we have seen for some of our other trades. But there is one other scenario that could bump this trade up to a 50%-plus annualized return.
Remember, the owner of a call option has the right to buy stock at the strike price. And for American options, the contracts can be exercised at any time before the expiration date.
Since the dividend is paid to shareholders of record on April 10, the owners of the option contract may have an incentive to exercise their right early, allowing us to close out this trade in 15 days instead of waiting for the entire 52 days.
Of course, if the calls are exercised early, we will end up with an obligation to sell our stock without collecting the dividend. But in this case, we still recognize a $1.05 profit over a 15-day period, or 2.15%, which actually nets out to an annualized gain of 52.2%.
For the calls to be exercised before the April 10 ex-dividend date, we would need to see DRI trade significantly above the $50 mark. But considering the recent breakout and the strong fundamental news, it would not be unlikely at all to see the stock trade sharply higher and give us a great shot at booking that 52% profit.
Regardless of whether these calls are exercised early, this looks like an attractive setup with minimal risk and a strong return profile.
I'd love to hear how you like these trading signals. Are you involved with any of our covered call trades so far? Would you like to see more covered call setups? Did you know that you can put these trades in an IRA account to generate much higher returns for your retirement nest egg?
Please send your comments and/or questions to Editors@ProfitableTrading.com and mention this article on covered calls. I look forward to hearing from you.
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