Here is an example using today's prices. Buy UPS at $40. Sell Jan 2011 calls at strike price $40 for $9.80. Sit back and collect the dividend.
1. What can go right: If UPS is above $40 on expiration date in 2011. You will make 13.4% on the pure premium, which is $9.80 less the $5 you are in the money. This equals 7.3% annually, given just 22 months to expiration. The dividend is $1.80 and you only put up $35.80 to make the trade, which is equal to 5.14% dividend yield. Totally, this is 12.44% annually, which is taxed at a preferred low rate versus bonds. That's not important for IRAs or 401Ks, but very important in a taxable account.
2. What can go wrong: You are price protected to $35.80, but once you dip below that, you are losing on your principal. UPS can cut or eliminate their dividend. You can lose more than you can win.
So, you have a bond substitute with a great rate, but more risk than with AAA bonds (try finding some of those. And, if you do, remember that AIG and GE were AAA last year, so they are low risk, not no risk.)
Caveat Emptor. After decades of huge success with buy and writes, I have been cold on this strategy in the 21st Century. I am now convinced that the large premiums offset the downside for many stocks at this price level, but it is within the realm of possibility that I could be wrong again. <G> |
