A Guide for Capturing Dividends by Using Covered Calls

High-volatility trading environments can be great for some traders and horrible for others. It just depends on what kind of trades they take and what strategies they partake in. One strategy that works in a number of different environments? Capturing dividends via covered calls.

So how exactly do we go about capturing dividends?

Capturing dividends is a relatively conservative options strategy. It doesn’t rely on home runs, but rather, a series of continuous singles and walks to get on base. Is it the sexiest strategy out there? Not really. But when it comes to profits, there’s no reason to discriminate.

Understanding Dividends

Our goal here is pretty simple: Capture the dividend. To do it, we first need to select a dividend-paying stock. It tends to work best with names that pay out a decent yield. 2.5% to 3.5% and above work well, but below that it can become more frustrating for investors.

Next, we’ll need to see when the company plans on paying that dividend and when the stock will go ex-dividend. A stock goes ex-dividend on the first day of trading where new investors will miss the dividend payment. Remember that it takes three days for a trade to settle. So if the record date is April 4th, we need to own the stock at the close of business on April 1st. In this case, the ex-dividend date would be April 2nd. Here’s a visual:

Capturing Dividends

The company generally announces when the record dates and payment dates are, the latter being the date that investors who own stock on the record date will collect their payout. If it’s a quarterly dividend, the stock will have four record dates, ex-dividend dates and payout dates per year.  

Capturing Dividends

The ex-dividend date has a big impact when it comes to capturing dividends. But before we get into the why, let’s talk about the trade’s structure. What we’re doing here is selling an in-the-money covered call. We want to do so before the company’s ex-dividend date. Inevitably, some call-holders in the name will exercise their long call options in order to collect the dividend. 

Say ABC is trading for $63, pays out a 2.8% quarterly dividend yield and goes ex-dividend on March 5th. Currently, it’s February 20th.

We may buy 100 shares of ABC and then consider selling the March $60 in-the-money call option as part of our dividend capture strategy. With about a month until expiration, let’s say the $60 call is going for $4.00. We sell that call, knowing that unless ABC falls more than ~5% to below $60, we could get exercised.

There are a number of scenarios that can play out now:

  1. 1. Shares stay above $60 but we don’t exercised before the ex-dividend date, allowing us to collect the 42-cent-per-share dividend ($42) plus keep the net credit we collected on the $60 covered call ($1.00). In all, this will allow us to pocket our maximum profit of $142, a 2.2% return, excluding commissions.
  2. Shares stay above $60 but we are exercised before the ex-dividend date. This means we don’t collect the dividend, but we do keep the $1.00 net credit.
  3. Shares tumble to $61, we’re exercised and we still keep our $1.00 net credit.
  4. Shares tumble below $60 before the ex-dividend date and close at $59 on expiration. Ultimately our loss on the stock omits our gain on the net credit, but we still collect the $42 dividend. 

De-Risking While Capturing Dividends

Investors need to consider the potential decline in their initial equity position. In our case above, we are buying 100 shares of ABC at $63. We are “covered” down to $60, below which we start seeing our net credit erode. Technically speaking, we are covered a bit more should we collect the dividend, but since it is not known whether we will collect the dividend, we cannot guarantee that income.

So how can we derisk? The first option is simple: lower the strike price of the covered call. If we sell a lower strike price on ABC, it lowers the odds that ABC will decline below our short call. However, that also lowers the time value in the short call. 

Here’s an example: 

Stock at $63, sell the $60 call for $4.00; Intrinsic Value = $3.00, Time Value = $1.00

Stock at $63, sell the $55 call for $8.50; Intrinsic Value = $8.00, Time Value = $0.50

There’s nothing wrong with this strategy per se, but just know that it’s a more conservative strategy for capturing dividends.

One other way to lower investors’ risk? By implementing a protective put. Of course, when we buy 100 shares of stock, sell a covered call and buy a put, this is known as a collar. This protective strategy cuts into our potential upside, but also limits our downside. The move will generally cut into most of the net credit we receive in the trade, but eliminates our risks too. If we’re lucky, we’ll still be able to collect our dividend if we’re not exercised on the short calls.  

Using Options Party

The Option Party platform can easily help us with capturing dividends. For this strategy, I like to make an entirely new screener. Adjust the level of probabilities you want for the trade, but remember that most of the trades will have a 0.1% chance of total loss, because in order to absorb the maximum loss, the stock would need to go to zero.

Under the “Stock – Financials” tab we can select stocks with a minimum yield and under “Options Expiration” we can make sure the stock or ETF goes ex-dividend before expiration. Under the same category, we can also adjust the maximum days until expiration.

Traders can tailor the rest of the screener to their specific preferences. I personally like to use the Opportunity Alerts feature, so I don’t have to constantly refresh the results and perform manual searches. The system will simply let me know when new trades pop up.

Remember, just because the strategy only returns 1% to 3%, generally speaking, doesn’t mean it should be ignored. A 2% return per month comes out to a 24% gain on the year, which is usually enough to beat the averages.

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