Sell covered calls to boost returns? No thanks

Share

My investment adviser is suggesting I "turbocharge" my returns by writing covered call options on my portfolio of blue-chip dividend stocks. What are the benefits and risks of this strategy?

As an investor focused on the long run, I'm not a fan of covered call writing. The strategy essentially sacrifices long-term gains for short-term income – not a good trade-off, in my opinion.

When you write – or sell – a call option, you give the option buyer the right to purchase your shares at a specified price by a specified date. In exchange, you collect a small payment or "premium." It seems like free money, but it isn't.

If the stock muddles along and doesn't rise above the "strike price," the buyer will not exercise the option and you will keep the shares and the premium. This is a win-win for you.

But if the market price of the shares rises above the strike price, the option holder will exercise his or her right to buy the shares from you. You keep the premium, but you lose your shares, which you must sell at a price below the market. The option premium will offset some or all of that loss, but now you'll have to redeploy your cash into something else. This makes selling calls incompatible with a buy-and-hold dividend-investing approach.

"Because the seller of the covered call may have to give up his stock, this strategy is more appropriate for investors who are seeking current income as opposed to those who are trying to build wealth via dividend reinvestment," writes Marc Lichtenfeld in his book, Get Rich with Dividends.

Over a time horizon of, say, 10 years, chances are good that some of your stocks will get called away, "disrupting the compounding dividend machine," Mr. Lichtenfeld says. Not only that, but you'll have to pay capital gains tax on both the option premiums and on any gains incurred when your shares are called away. In a rising market, selling covered calls can be especially dangerous because you risk missing out on some of the gains.

Let's compare the recent performance of two exchange-traded funds – one that uses covered calls and one that doesn't.

Over the past three years, the BMO Covered Call Dow Jones Industrial Average Hedged to CAD ETF (ZWA-TSX) posted an annualized total return – including dividends – of about 6.4 per cent. Its sister fund (ZDJ-TSX), which does not use covered calls, had an annualized total return of 7.6 per cent.

Clearly, an investor would have been better off simply buying the plain-vanilla Dow Jones index ETF.

For all of these reasons, I believe that buying and holding a portfolio of high-quality, dividend-paying stocks or low-cost funds is a better way to go.

If you need income beyond the dividends you receive, you can always sell a chunk of shares – and, unlike with covered calls, you'll control the timing.

How do I calculate the adjusted cost base (ACB) of shares that I bought in different accounts and prices? If I sell some shares, do I use the ACB only for the account in which the sale occurs, or do I use the ACB across all of my accounts? What if my wife also owns the shares?

You need to know your ACB in order to calculate your capital gain, or loss, when you sell your shares. Your ACB is based on shares purchased in all non-registered accounts in your name; you can exclude registered accounts – such as registered retirement savings plans and tax-free savings accounts – because no capital gains taxes apply in those cases.

For example, say in 2010 you bought 100 shares of BCE at $30 in a BMO InvestorLine non-registered account. Then in 2013, you opened a non-registered account at RBC Direct Investing and bought an additional 200 BCE shares at $45.

Your total ACB would be the $3,000 cost of the initial 100 shares plus the $9,000 cost of the additional 200 shares, for a total of $12,000 (plus any commissions incurred). Your ACB per share would be $12,000 divided by 300 shares, or $40 a share.

Now, say you decide to sell 100 shares of BCE at their current price of about $58. Your capital gain would be the sale proceeds of $5,800 minus the ACB of $4,000 on these shares ($40 times 100), which works out to $1,800 (minus any sale commissions). Your capital gain would be the same regardless of whether you sell the shares in your BMO or RBC account.

If your wife owns BCE shares in a separate non-registered account, these shares would not be included in your ACB or capital gain calculation. However, if you and your spouse hold BCE shares in a joint non-registered account, your share of the BCE stock – based on the proportion of the capital that you contributed to the joint account – would be included in your ACB, according to Dorothy Kelt of TaxTips.ca.

It's important to understand that your ACB per share does not change when you sell a portion of your shares. Returning to the example, the ACB of the remaining 200 shares would still be $40 a share, or $8,000 in total.