After the big run in the prices of high yield shares, many investors who own these shares are sitting on a substantial amount of unrealised profits. These investors are getting nervous that a market correction might wipe out these unrealised gains but they also do not wish to sell the shares as they want to continue to collect the dividends.
I found myself in this predicament with my Legacy Portfolio this year. This portfolio comprises of stocks that have a strong history of dividend growth. My plan is to hold these stocks forever as increasing dividends would provide me with an income that (hopefully) will keep up with inflation when I retire. One of the stocks in this portfolio is McDonalds (MCD) which I purchased in February this year for around $95 per share. The stock price quickly ran up to $103 shortly after I purchased it as shown in the chart below. After that it struggled to make new highs and eventually fell below the short-term support of $100. It was then clear to me that the strong uptrend was over, at least for a little while.
MCD pays a nice dividend of 77 cents per share every quarter so I am happy to continue to own the shares. However, I also want to take some of my unrealised capital gains off the table in case the share price falls. When the share price rallied back to $100, I decided to sell some ATM calls for which I received a premium of $2.38 per share. After a brief rally, the share price continued its downward trend. When the calls expired on August 16, the share price was back at $95 so my calls expired worthless but I got to keep the $2.38 of call premium.
MCD shares rallied back up in September but struggled to break above $99 so I decided to sell some more calls and collected another 89 cents of premium. The share price has since fallen back to $95 so I have lost almost all my unrealised profits in the shares. However, I have managed to collect $3.27 of realised capital gains from selling call options.
In our Vanilla Model Portfolio, we used covered calls to generate income. However, you can also use covered calls to partially hedge your long-term share holdings when you are worried that the share price might fall, as shown in our MCD example above.
Disclaimer: This post is for educational purpose only and should not be treated as investment advice. This strategy would not be suitable for stock investors who are not familiar with exchange traded options. Any reader interested in this strategy should do their own research and seek investment advice if required.