Microsoft Stock: Covered Calls for Income (NASDAQ: MSFT)

Our recent article on covered call options generated positive feedback and sparked readers’ interest in learning more about covered calls, specific stocks for covered calls, and options in general. For now, we are focusing on a combination of the first two: adding to the lessons learned from previous articles and identify more stocks that fit this strategy.

To avoid being redundant, this article will only cover comments and new learnings from the previous article and introduces Microsoft (NASDAQ: MSFT) as another candidate for repeatable covered calls for continued additional income. Why Microsoft, you might be wondering? We’ve covered that below.

Let’s first look at some learnings and discussions in the previous article’s comment stream.

Things to know – Appendix

• This may seem obvious to some, but readers have brought it up. The strike price of your covered call option must always be above the current market price. In other words, the out of the money option to ensure that your net profits (capital gains) grow with the premium in case you are called. The goal here is not to get the highest bounty, but to hold onto the shares and increase revenue by doing so.
• Some readers have asked if there are any ETFs that mimic the covered call strategy. Indeed, there are a few. The S&P 500 Covered Call ETF (XYLD) comes immediately to mind. While buying this ETF may give an investor exposure to this strategy, it does not give them the means to “milk” their existing stocks for additional income.
• Some readers have argued that being range bound and lacking positive catalysts are reasons why stocks like AT&T(T) should be avoided for covered calls. We believe the exact opposite is true. For us, as well as most covered call users, the intention is not to actually lose the cow but to continue milking the cow for as long as possible. This means we don’t like being called back and losing our shares and trade the lower premium for repeatability.
• Growth stocks offer more premium, but as stated in the point above, the higher the volatility, the higher the premium and the higher the likelihood that you will be trailed and lose your stocks.

Now let’s get to the important question.

Why Microsoft?

We covered Microsoft fundamentals in a recent article here. Thus, this article will focus on whether Microsoft is a good candidate for covered calls and whether the premium is significantly higher (in percentage terms) for stocks like Microsoft compared to traditional slow moves like AT&T.

• Microsoft has a low beta of 0.90, which means it moves slightly ahead or behind the market. This is a pretty good beta for a covered call writer, as the writer is more interested in increasing the earnings/returns of the underlying position than selling it. Believe it or not, the chart below suggests that Microsoft has a narrower trading range [10%] that AT&T covered in the previous article [11%].

• Microsoft actually pays a solid dividend and has a good track record of dividend growth. It’s just that the stock has run 10 times from its $30 range that the yield looks weak. Writing covered call options increases the income when one wants to hold the stock, but the return seems low.
• Investing is a game of probability in our opinion and not a certainty. Most brokers provide tools like the ones shown below to help you gauge the likelihood of success in a particular trade. The example below shows that Microsoft has an 87% chance of trading below $325, an 82% chance of trading below $320, and a 76% chance of trading below $315 when this string is options expires. The higher the strike price, the lower the premium. We choose a strike price of $320 as the middle ground here.

Let’s look at the returns and possible scenarios.

• If Microsoft remains stable or below $320: the premium of 2.11 cents per share represents a return of 0.70% on the underlying stock price of $295. Before you scoff, keep in mind that this return is for a month and that Microsoft annual the yield is 0.84% ​​to date. As covered call nibblers, we seek repeatability on large one-off bonuses at the risk of being called back.
• If Microsoft exceeds $320: the writer of the covered call will be obliged to sell the shares in this case. That might not be so bad considering that Microsoft is currently trading at $295 and selling at $320 represents an 8.50% return in one month. Not to mention the small return of 0.70% above as a bonus. So the total return in this scenario is $320 + $2.11 – $295 = $27.11 per share or a nice 9.18%. For comparison, for a fairly similarly dated option chain (one month), AT&T’s yield was also around 9%.
• What if Microsoft exploded? : This is the only downside of writing covered calls where you end up selling your shares at the agreed strike price, but the stock has gone above the strike price. You would still sell at $320 even if Microsoft were at $330, for example. But it’s no different from going long on a stock and selling it, only to see it go higher. The current market seems to come and go without clear conviction. The odds of even a stock like Microsoft gaining 10% with no news or earnings report are slim.

Conclusion

In the AT&T and Microsoft examples, we have chosen strike prices around 10% above the market price and the returns/call scenarios covered in both cases are more or less the same. While some readers may scoff at premium returns like 1%, we’re looking at the repeatability factor. A monthly compound rate of 1% can suddenly add double-digit returns to your portfolio, with no risk to your fluent capital (notwithstanding giving up future earnings). That said, it will be interesting to assess a more volatile and non-dividend paying stock next. But for now, Microsoft is one step ahead of AT&T.

Please continue the discussions in the comments stream and we look forward to more reader feedback.