7/5/12 Trade Alert: Another Ex-Dividend Date

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

Option Spread on Verizon Communications (NYSE: VZ)

“Buy to Close” September $43 Call


and


“Sell to Open” October $45 Call


Option Symbols: VZ120922C43 and VZ121020C45

Limit Order Price: Net debit of $1.08 or less ($108 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” September $43 call for a debit of $2.14 or less ($214 per contract)


(b) “Sell to open” October $45 call for a credit of $1.06 or more ($106 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 (VZ) stock. Specifically, I want to buy to close the September $43 call and sell to open the October $45 call for a net debit of $1.08 per share or less.

  • For a two-part trade:
I’d like to buy to close the September $43 call on Verizon (VZ) stock for a debit of $2.14 per share or less.

I’d like to sell to open the October $45 call on Verizon (VZ) stock for a credit of $1.06 per share or more.

Please note: The important thing is to achieve a net debit on the roll (i.e., both trades) of $1.08 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 debit of the overall roll in mind.

Rationale for Trade:

On July 6th, Verizon goes ex-dividend, which means that today (i.e., July 5th) is the last day for the call owner to exercise the option to buy the stock and be entitled to receive the stock’s $0.50 per share quarterly dividend. When we initially rolled the June covered call to September, I mentioned that there was a chance that an early roll of the September $43 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 stock has rallied above $43 to $44.95, making the September $43 call in the money by $1.95 per share. In many cases, 78 days of time value (i.e., until September expiration) for a stock that’s $1.95 in the money would be worth a lot more than a $0.50 quarterly dividend, but Verizon is a very low-volatility stock (implied volatility of September options is under 20 percent), so time value is not worth much. The result is that the September $43 call has only $0.19 of time value remaining. Early exercise is therefore likely to occur because the dividend received from exercising the September $43 call to obtain the stock is larger than the time value forfeited by exercising early.

There is a $1.08 cost for doing the recommended roll and protecting our Verizon stock from early exercise. But by rolling our September $43 call strike to an October $45 call strike, we are increasing our appreciation potential in the stock by an extra $2.00 through October options expiration.

Rolling Verizon for a Debit?

An important concept to remember is that the $1.08 per share debit on this roll is not a loss. As owner of a stock currently trading at $44.95, you have captured the full $1.95 in price appreciation that Verizon stock has achieved above the September $43 call strike. The debit price paid for rolling the covered call reflects the stock owner/call seller’s obligation to give that $1.95 in stock-price appreciation to whomever owns the September $43 call.

In other words, the $1.95 per share is a forfeited gain–not a loss. By selling the October $45 call for $1.06, we are taking back $1.06 of the forfeited stock-price gain, leaving us with a forfeited gain of only $0.89 ($1.95-$1.06). 

Over time, academic studies have shown that insuring your portfolio from price declines with covered calls is much more important for long-term wealth generation than simply owning the stock and benefiting fully from every stock-price gain.

Stocks fluctuate in price and don’t always rise. When stock prices fall or remain stagnant, rolling covered calls brings in credits and over the long term the credits received from rolling covered calls far exceed the infrequent debits paid to roll. In addition, by rolling the covered call for a debit rather than allowing the stock to get called away, you continue to receive stock dividends, which in the case of income stocks like Verizon are substantial!

Bottom line: don’t be concerned about rolling a Verizon covered call for a debit now and then. It’s just part and parcel of the journey to higher returns.

Price Adjustment Regarding Verizon 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 your Verizon stock). We will need to be flexible in our limit price and adjust if necessary as we get nearer to the market close on Thursday, July 5th.

The limit debit price of $1.08 I suggest above is a starting point. If it doesn’t fill within a few hours, I recommend raising the limit debit 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.

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