Seagate Technology (STX) is one of the stocks that I am holding in my retirement account. I purchased it as part of my focus on dividends since it had a 4% yield at the time. The stock increased in price and I ended up selling it in late June for a 23% annualized profit. But I immediately repurchased it again and instituted my hedging strategy since I still fell like the stock had some decent potential for further gains.
Well this week, STX reported earnings. It seemed at first like investors were going to be disappointed as the stock had opened down over 5% from above $30 per share to the mid-$28 range. But gradually, the stock began to improve and closed right at $30 per share even though the broader market was down for the day.
Why the Strength?
Well in addition to reporting earnings and giving a somewhat disappointing outlook, Seagate announced that they were increasing their dividend from $0.25 per share to $0.32 per share! Assuming that the dividend remains at that level for the next year, the yield on the stock at $30 per share is just over 4.2%. I think that investors may have figured that out and realized that maybe it is worth the investment to get a decent return with the potential for some capital gains.
Now if you are like me, then you can have your dividends and hedge the stock also. Right now, I am sitting on protective puts at $25 and $27 per share with outstanding calls at $28 and $30. My basis for all the shares I own are $27.16. If STX remains above $30 per share for the next eleven trading days, then they will all be called away at an average of $29 giving me a $1.84 profit. Plus I will get the dividend since the ex-dividend day is August 10th.
It is possible that my $28 strike calls could get exercised before then if someone wants to try and capture the dividend. However, they would have to make sure that it is worth it when compared with the price paid for the option and the amount of capital required to exercise. Even so, I would still have a profit at that price.
I was encouraged to see that the dividend seemed to help stabilize the stock and provide a floor for the shares. Of course, it isn’t that surprising since a significant portion of historical stock market return can be attributed to dividends. It only makes sense that stocks of companies that return money to shareholders would be in demand and perform well over time.
How appropriate is it that we should wrap up our discussion of covered call time premium for the week on the day before option expiration? Even though options expire tomorrow on Saturday, today is the last day that they could trade. So for all practical purposes, I consider the third Friday of the month as the more important day when it comes to trading options.
Additional Factors Affecting Options Prices
We have already discussed a couple of the factors that influence the premium that one might receive for selling a covered call and will summarize those at the end, but another important factor that can influence the price of an option contract is the volatility of the underlying stock.
This should make sense since the way to profit with an option is by having a significant change in the price of the underlying stock. If a stock only typically moves $5 in a month, you can bet that options priced $10 away from the market price have very little value. However, if the stock is highly volatile and will move $20 up or down in a month’s time, then that same contract would be worth a lot more.
Finally, one needs to consider the impact of interest rates and dividends on the premium of a call option. In a higher interest rate environment, the call premiums tend to be higher since the cost to purchase shares of stock outright with borrowed money is more. This makes a call option a viable alternative as a form of leverage and so the price increases somewhat. Of course, this will benefit those selling covered calls.
On the other hand, a stock that pays a dividend will tend to have a lower premium since the stock should be losing value when it goes ex-dividend. On a side note, dividend paying companies tend to be less volatile.
Five Factors that Influence Call Option Premiums
To summarize, there are five main factors that work together to determine the ultimate price of a covered call:
- Relationship between the stock price and the strike price
- Time until expiration
- Volatility of the underlying stock
- Prevailing interest rates
- Dividends paid by the underlying stock
That concludes this week discussing covered calls and premiums. Feel free to ask any questions or suggest topics for the future.
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