REIT Covered Call Portfolio-Update

In my blog on March 17th, I constructed a portfolio of six high-paying dividend stocks and wrote the April covered calls against them. Since today is options expiration, I want to examine the portfolio and see how we did.

The stocks I chose all had to have dividend yields greater than 3%, pay a dividend between then and today, be optionable, and not be in a down-trend. All of the candidate stocks were REITs (real-estate investment trusts): Avalon Bay (AVB), Cali Realty (CLI), Developers Diversified (DDR), Entertainment Properties (EPR), Essex Property Trust (ESS), and UDR (UDR). I constructed a virtual portfolio of all of these stocks by buying 500 shares of each at the March 17th closing price and writing 5 call contracts on each at the option closing price. The call strikes were either at-the-money (ATM) or slightly out-of-the-money (OTM).

Fortunately, all of the stocks selected did quite well, gaining between 5-15% in value since then. I did make one mistake in selecting UDR. The information that was given to me from a person who shall remain nameless (Dimitri) stated that the UDR dividend was to be paid on April 15th. That was inaccurate as the dividend pay date is April 30th. Since the pay date is later than today, the day of options expiration, I'm not going to include it in this discussion. But if I had owned the stock, it would have returned over 5% with the covered call strategy which is not too shabby.

Here's how I set up the portfolio:
1. Used end of day data on 3/17 for the stock and options prices.
2. Used middle of the day data today (4/18) for the stock prices (I'm writing this before the close.)
3. Bought 500 shares of each stock and sold 5 April call contracts.
4. Commissions are included ($10/stock trade; $15/options trade).

The following is a chart of the parameters that were used. Note that all prices are on a per-share or per-contract basis.

Since all of our options expired in the money, all of our stocks will be assigned. That means that if we want to own them again, we'll have to go out and buy more. It also means that we didn't get to participate in any price movement above the strike price which is unfortunate since all of the stocks did very well.

The next chart shows you the difference in portfolio performance. The first column shows the returns on a portfolio with no covered calls, assuming that you would have sold your stocks today to realize these gains. The second is the covered call portfolio. Note that although the total return is a nice 7% gain, it's 4% short of the uncovered portfolio.

So what have we learned from this lesson? That covered calls aren't such a good idea? Well, yes and no. We would have done a lot better if we had waited to sell calls when the stock was making a new high, but if course one never knows when a stock is at a local high or is poised to go higher. Certainly, when the stock is taking a breather is not the best time to cover.

Perhaps a better strategy is to combine the two. That is, when your stocks and the market are moving up, you refrain from covering. During this time you'll own the stock and collect the juicy dividends. After your stocks have enjoyed a long run-up is when you might consider writing calls. This will offer you some downside protection just in case things start to unravel without digging into your profits.

The point I really want to make here is that paper trading your strategies will allow you to make better investment decisions when you do decide you're ready to put them into practice. I hope this exercise has done just that.