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

Stock Market


Microsoft France headquarters entrance in Issy les Moulineaux near Paris

Jean-Luc Ichard / iStock Editorial via Getty Images

Our recent article on covered calls generated positive comments and interest from readers to learn more about covered calls, particular stocks for covered calls, and options in general. For now, we are focusing on a combination of the first two: adding to the learnings from the previous articles and identifying more stocks that fit this strategy.

To avoid getting redundant, this article will cover only the feedback and new learning from the previous article and presents Microsoft (MSFT) as another candidate for repeatable covered calls for continuous additional income. Why Microsoft you may wonder? We’ve covered that below.

Let’s first look at some learning and discussions in the previous article’s comments stream.

Things to know – Appended

  • This may sound obvious to some but readers brought this up. The strike price of your covered call should always be above the current market price. In other words, out of the money option to make sure your net profits (capital gains) on the way up along with the premium in case you get called. The goal here is not to net the highest premium but to retain the shares and increase income for doing so.
  • Some readers asked if there are ETFs that mimic the covered call strategy. Sure enough, there are a few. The S&P 500’s Covered Call ETF (XYLD) readily comes 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 argued that being range-bound and lacking positive catalysts are reasons stocks like AT&T (T) should be avoided for covered calls. We believe the exact opposite is true. For us, as well as most of the covered call users, the intent is not to actually lose the cow but to keep milking the cow for as long as possible. This means, we do not like to be called away and lose our shares and are exchanging the lower premium for the repeatability.
  • Growth stocks do offer more premium but as hinted in the bullet above, the higher the volatility, the higher the premium and the probability that you get called and lose your shares.

Now onto the important question.

Why Microsoft?

We have covered Microsoft’s fundamentals in a recent article here. So, this article will focus on whether Microsoft is a good candidate for covered calls and if the premium is significantly higher (in terms of percentage) for stocks like Microsoft when compared to traditional slow movers like AT&T.

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

MSFT Chart (Think or Swim)

  • Microsoft actually pays a solid dividend and has a good dividend growth history. It is just that the stock has run 10 folds from its $ 30 range that the yield appears small. Writing covered calls augments the income when one wants to hold the stock but the yield appears low.
  • Investing is a game of probability in our opinion and not a certainty. Most brokers provide tools such as the ones shown below to help you evaluate the probability of success in a particular trade. The example below shows that Microsoft has an 87% chance of trading below $ 325, 82% chance of trading below $ 320, and a 76% chance of trading below $ 315 when this Option chain expires. The higher the strike price, the lower the premium. We are picking $ 320 strike price as the middle ground here.
MSFT Stock Chart

MSFT Chart (Think of Swim)

Let us look at the returns and possible scenarios.

  • If Microsoft remains flat or below $ 320: The premium of 2.11 cents per share represents a return of .70% on the underlying share price of $ 295. Before you scoff at it, keep in mind this return is for a month and Microsoft’s annual yield is 0.84% ​​as of this writing. As nibblers on covered calls, we are looking at repeatability over one-time large premiums at the risk of getting called away.
  • If Microsoft goes above $ 320: The covered call writer will be forced to give up the shares in this case. This may not be too bad considering that Microsoft is currently trading at $ 295 and selling at $ 320 represents an 8.50% return in a month. Not to forget the little .70% return above as premium. So, the total return in this scenario is $ 320 + $ 2.11 – $ 295 = $ 27.11 per share or a healthy 9.18%. As a comparison, for a fairly similarly dated options chain (one month), the AT&T return was around the 9% range as well.
  • What if Microsoft blasts off ?: 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 blown past the strike price. You’d still be selling at $ 320 even if Microsoft was at $ 330, for example. But this is no different from being long a stock and selling it, only to watch it go higher. The current market seems to ebb and flow without clear conviction. The odds of even a stock like Microsoft gaining 10% on no news or earnings report are low.

Conclusion

In both the AT&T and Microsoft examples, we picked strike prices approximately 10% above the market price and the covered call returns / scenarios in both are more or less the same. While some readers may scoff at premium returns like 1%, we are looking at the repeatability factor. A steady 1% compounded monthly can suddenly add double-digit returns to your portfolio, with zero risk to your current capital (giving up future gains notwithstanding). That said, it will be interesting to evaluate a more volatile, non-dividend paying stock next. But for now, Microsoft is a step up from AT&T.

Please keep the discussions going in the comments stream and we look forward to more feedback from readers.



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