Please Note: This recommended trade only applies to those Personal Finance Income Plus members who already have a position in Verizon Communications stock. Do NOT do this trade as an initial position.

1. Sell Diagonal Spread on Verizon Communications (NYSE: VZ)

    “Buy to Close” May $38 Call

and

    “Sell to Open” June $39 Call

Option Symbols: VZ120519C38 and VZ120616C39

Limit Order Price: Net debit of $0.27 or less ($27 per spread)

If your broker doesn’t allow option spreads, then you’ll have to do two separate single-option trades:

(a) “Buy to close” May $38 Call for debit of $0.76 or less ($76 per contract)


(b) “sell to open” June $39 call for credit of $0.49 or more ($49 per contract)

Directional View for Underlying Stock: Neutral

Personal Finance Portfolio: Income

•    Tell your broker:

For a diagonal spread (preferred)

I’d like to enter an option spread order on Verizon Communications (VZ) stock. Specifically, I want to buy to close the May $38 call and sell to open the June $39 call for a net debit of $0.27 per share or less.

• For a two-part trade:

I’d like to buy to close the May $38 call on Verizon Communications (VZ) stock for a debit of $0.76 per share or less.

I’d like to sell to open the June $39 call on Verizon Communications (VZ) stock for a credit of $0.49 per share or more.

Please note: The important thing is limiting the net cost of the roll (i.e., both trades) to $0.27 or less. The specific limit prices of the individual “buy to close” and “sell to open” trades are just starting points and should be adjusted as needed, keeping the net cost of the overall roll in mind.

Rationale for Trade:

On April 5th, Verizon goes ex-dividend, meaning that the last day to buy the stock and be entitled to receive the stock’s $0.50 per share quarterly dividend is today (i.e., April 4th). As I wrote in the initial February trade recommendation, an early roll of the May $38 call may be warranted if it is in the money on the day prior to the ex-dividend date because the call is subject to early exercise.

Early exercise is likely if the call owner will receive more money by exercising and receiving the stock dividend than he loses by forfeiting the time value remaining in the price of the call. When you exercise an option, you only receive the intrinsic value of the option and forfeit any remaining time value.

In the case of Verizon, the low-volatility market environment we currently are in has left the May $38 call with only $0.30 per share in time value remaining. Since the quarterly dividend of $0.50 is larger than this $0.30 of time value, it is a virtual certainty that the owner of the May $38 call will exercise it by the close of trading today. Unlike at expiration, when all in-the-money call options are automatically exercised, in-the-money call options prior to expiration are only exercised if the call owners affirmatively notify their brokers of their desire to do so.

Some of these call owners may be absent-minded and forget to exercise, and a “dividend capture” cottage industry exists of traders who intentionally sell an in-the-money call the day prior to a stock’s ex-dividend date in the hope that the call owner forgets to exercise. However, most call owners do remember to exercise so the prudent thing for us to do is to roll the May $38 call to a later expiration and/or higher-strike call that is not vulnerable to early exercise.

When feasible, the preferred strategy is to roll to the same strike in the next expiration month for an additional credit. In our case, that would mean rolling into the June $38 call, which does have more time value than the May $38 call but not much more. In the current low-volatility market environment, the June $38 call unfortunately only has $0.49 of time value which is still less than Verizon’s $0.50 quarterly dividend. Not good enough.

That leaves us with the June $39 call which–like the June $38 call–has $0.49 in time value but–unlike the June $38 call–is out of the money by $0.54. Any June $39 call owner who exercised would be buying the stock at $39 and selling it in the open market for $38.46 for a $0.54 loss. They would receive the $0.50 dividend, but the net result would still be a loss on the exercise of $0.04, which is not worth doing. Consequently, rolling into the June $39 call assures that our Verizon stock will not be called away at $38 and we will receive the $0.50 quarterly dividend. See the table below comparing the three different call option strikes discussed above:

Verizon is Trading at $38.46

Dividend = $0.50

There is a $0.27 cost for doing the recommended roll and protecting our Verizon stock from early exercise. But even after subtracting the $0.27 cost from the initial $1.05 credit received back in February for selling the May $38 call, we have an overall net credit of $0.78 ($1.05-$0.27). A $0.78 net credit still amounts to an added yield of 2.1 percent based on the initial stock price back in February of $37.83.

This remaining $0.78 net credit is due to the fact that we have already benefited from $0.29 in time decay from selling the May $38 call (price has decayed from $1.05 when we initially sold it in February to its current price of $0.76) and are receiving $0.49 in additional income from selling the June $39 call now.

Furthermore, by rolling our May $38 call strike to a June $39 call strike, we are increasing our appreciation potential in the stock by an extra $1.00 through June options expiration.

Price Adjustment Regarding This Trade

Unlike when we open an initial trade, this trade involves closing an in-the-money call option before it gets exercised early against us. Consequently, we do not have the luxury of patience and possibly passing on the trade (unless you are willing to sell the stock). We will need to be flexible in our limit price and adjust if necessary as we get nearer to the market close on Wednesday, April 4th.

The limit price I suggest above is a starting point. If it doesn’t fill within a few hours, I recommend raising the limit price by a few cents per share and waiting a few hours. If this adjusted limit price doesn’t fill, adjust again by a few more cents. Repeat the process until you get filled.