If you are using soon-to-expire options as part of a swing trading strategy, one enhancement to the strategy can increase your income substantially. By timing entry and exit with ex-dividend date in mind, you gain exceptionally high annualized returns and can churn capital in and out of positions to great advantage.
Here is how it works:
1. You time the purchase of 100 shares of stock immediately before the ex-date. This is the date that shareholders of record earn dividends, even though dividends are not paid until several weeks later.
2. At the same time or immediately before the ex-date you sell a covered call as few points as possible in the money, knowing that the stock’s price is likely to decline. This decline takes place to offset the company’s obligation to pay dividends.
3. The covered call is closed at a profit as soon as possible, probably the day after ex-date. This creates an immediate profit from the net difference between the opening sale and closing purchase.
4. As soon as the stock becomes profitable, shares are sold and replaced with 100 shares of another stock with ex-date coming up within the next week.
There are, of course, market risks associated with this strategy. For example, what if the stock’s price does not rise again following the ex-date decline? This is the equivalent of market risk you face just by owning 100 shares. The difference, however, is that with this strategy you have two additional sources of income, and both reduce your net basis. First is the profit on the net exchange of the covered call, and second is the dividend income you are going to receive in a few weeks.
To calculate your true net basis in the stock, reduce your cost by the amount of these two income sources. A strong, well-selected company’s stock is not likely to fall very far or for very long, assuming the market is steady at the moment. If it is too volatile, you have to question whether any market positions make sense.
The advantage to this stock-option-dividend combo is that it gives you a better shot at profits than just owning shares. Even if you lose, the basis in stock is less than what you paid for it, making recovery much easier.
All option-based strategies contain risks, but this one combines the best of three different market ideas: Owning stock of well-selected companies, getting the dividend even if you only own the stock for a few days, and increasing profits with covered call writing.
This can work as a very short-term strategy. The relatively small dollar amounts of profit are actually considerable when reviewed on an annualized basis. For example, a stock yielding a 3% return is decent. But if you only own the stock for 6 days, that translates to 15% for one month, or 180% for a full year. Annualizing does not ensure those kinds of profits, but for comparative purposes, this makes the point: Covered call writing with swing trading around ex-date is an intriguing idea.