ByJim Pearce • November 29, 2018 • Stocks to Watch
Did you know that there is a way to double or even triple the income you receive from the stocks you own, in addition to the dividend? It’s a conservative options strategy using the best stocks for covered call writing.
Covered call writing allows you to earn more income on the stocks that you own. Basically, you are selling a stock’s future appreciation potential in exchange for a premium. You get to keep that premium whether the stock’s share price goes up or down.
If the stock rises in value, it may end up getting bought away from you. In that case, you simply take those profits and sink them into another stock to repeat the process.
If the stock does not rise in value, the covered call option will most likely expire worthless. In that case, you get to keep the stock. You can write another covered call option against the same stock and repeat the process all over again.
For that reason, some investors refer to covered call writing as a “heads I win, tails I win” approach to owning stocks.
The Best Stocks for Covered Call Writing
If you’re in a hurry, below are our top picks for the best stocks for covered call writing:
- Best Buy (NYSE: BBY): Electronics retailer has fended off e-commerce threats and it’s still growing.
- United Parcel Service (NYSE: UPS): World’s biggest package delivery company.
- American Electric Power (NYSE: AEP): Largest electric transmission network in the U.S.
What Are the Best Stocks for Covered Call Writing?
The best stocks for covered call writing are those that buyers of call options believe are likely to appreciate in value soon. Therefore, you should look for stocks that possess the following traits when selecting the best stocks for covered call writing:
- Pays a current dividend yield of 3% or more
- Has a recent history of strong share price growth
- Is in a sector that is expected to perform well in the near term
A stock that pays a solid dividend yield is attractive for many reasons. You get paid to wait for the stock to appreciate, and you can reinvest that money into other stocks to compound your rate of return.
Stocks that have performed well recently are expected to outperform the market going forward. They get more attention from the mainstream media, which amplifies the herd mentality of the stock market.
Also, buyers of call options are willing to pay bigger premiums for stocks in sectors that are “hot” at the moment. That means as the seller of covered call options you can earn a higher return without having to take on more risk.
Read Also: Top 3 Best Dividend Stocks to Own
How Do You Determine What Companies Qualify as the Best Stocks for Covered Call Writing?
A list of stocks that meet those three criteria can be created by using an online stock screener such as the ones evaluated in this video:
However, that alone is not enough. A recent search using those criteria generated a list of nearly 100 companies. That’s too many, so you need to cull the list further by looking for names that investors will find attractive.
With trade tensions high, companies that generate most of their sales here in the U.S. are gaining in popularity. Stocks in the energy sector should be avoided since volatile oil prices scare away a lot of investors. In addition, companies that are category leaders are considered safer than those that are lesser known.
Below is a list of three stocks that we believe meet all of our requirements and are among the best stocks for covered call writing.
Best Buy
What is it?
Best Buy’s ubiquitous “big box” stores dot the American landscape, where customers can buy everything from smartphones to washing machines. The company has 125,000 employees and racked up sales of $40 billion in 2018.
You may recall that only a few years ago Best Buy was given up for dead by Wall Street on fears that e-commerce giant Amazon (NSDQ: AMZN) would put it out of business.
After bottoming out below $30 in January of 2016, BBY produced a steady stream of quarterly results that proved its strategy for fending off Amazon was working. Its share price doubled over the next two years as shown below.
Source: S&P Capital IQ
Why is it one of the best stocks for covered call writing?
It should be obvious by now that Best Buy has successfully countered Amazon and will be one of the retail sector’s long-term survivors. Even after its big recovery over the past three years, BBY is priced at only 12 times forward earnings.
While I don’t expect BBY to double again over the next three years, I do expect it to outperform the overall stock market. The company has more than twice as much cash as total debt, so it can afford to continue buying back its own stock. It also pays a dividend yield of close to 3%.
Best Buy continues to surprise Wall Street with strong quarterly results. In addition, the company raised its sales and profit guidance for 2019.
United Parcel Service
What is it?
UPS is the world’s biggest package delivery service. Although UPS operates in over 200 countries and territories, last year approximately 75% of its total revenue came from within the U.S.
The company separates its business into three basic segments: U.S. Domestic, International, and Supply Chain & Freight. The company posted strong growth in all three areas during the second half of 2018.
UPS invested nearly $5 billion into its business operations in 2018. UPS has the free cash flow to fuel these investments, allowing it to continue to enhance its capabilities and compete well against its peers.
Why is it one of the best stocks for covered call writing?
The recent downturn in oil prices should serve as another short-term boon for these shares. Fuel is one of the largest input costs for UPS and I can only assume that this steep swing wasn’t fully factored into management’s already bullish guidance.
UPS typically announces dividend increases in February of each year for the following March payment. After such strong earnings growth in 2018, we wouldn’t be surprised if the quarterly payment was increased to $1.00/share or more.
UPS has also used its cash flows to reward shareholders by an effective buyback program. Over the last 5 years, UPS’s buyback has reduced the company’s overall share count by 6.9%.
American Electric Power
What is it?
Rising utility giant American Electric Power serves 5.4 million customers across 11 states, primarily in the Midwest and Southwest. While AEP has more than 26,000 megawatts of generating capacity, its most attractive asset is its transmission network spanning more than 40,000 miles, the largest in the U.S.
With the rise of renewables, transmission is one of the utility assets that’s most likely to survive and thrive during the sector’s technological revolution. Indeed, all those new forms of generation need connections to the grid.
Now that its strategic shift toward fully regulated operations is largely complete, AEP is free to focus on investing and upgrading its regulated assets.
Why is it one of the best stocks for covered call writing?
Transmission is a big part of the company’s three-year $17.7 billion spending plan. In fact, the wires—transmission and distribution—account for nearly three-quarters of AEP’s capital budget. That should help drive above-average earnings and dividend growth of 5% to 7% annually. Meanwhile, AEP has relatively low leverage compared to its peers.
A strong balance sheet gives AEP the scope to make a sizable acquisition without compromising its credit rating. AEP has resisted the temptation to make an acquisition during the sector’s recent M&A deal frenzy.
Acquiring a small, regulated electric or gas utility could help boost AEP’s earnings toward the top of its targeted range. But even without such an acquisition, AEP’s capital plan gives it plenty of earnings power.
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