This article was originally published on TheStreet.com on May 22nd, 2014 at 6:30am EST
The following is an actual, “real life” example of a strategy we’re working on for a client — let’s call him Robert.
Robert’s father, Fred, worked for Chevron his entire career. Fred accumulated a sizable chunk of Chevron stock in his employer-sponsored plan, which he passed tax-free to his wife, Dottie, when he passed away several years ago. Today Dottie is 85 years old and those 10,000 shares of Chevron stock represent her entire investment portfolio. Since Fred passed away, Dottie has been successfully living off Chevron’s quarterly dividends.
Those dividends currently amount to about $45,000 annually — far from a fortune but, in addition to Social Security, it’s sufficient income for Dottie to pay her bills. Recently, though, Dottie’s medical costs have risen and she hasn’t been able to do as much for her grandkids as she’d like.
Robert is handling his mother’s affairs and wants to know what, if anything, could be done to generate additional income for Dottie.
The questions we asked Robert:
1) What is the cost basis of the Chevron shares?
- The cost basis isn’t zero, but it’s pretty darn close. Cost basis did step up to market when Fred passed, but unfortunately that was almost 20 years ago, so the basis is about $25 per share. With Chevron currently trading around $125, selling any or all of the shares will result in a substantial tax bill — that’s not a great option.
2) Is there an emotional attachment to the shares?
- You bet there is.
3) Are Dottie’s income needs being met?
- Yes, though as mentioned above, she has recently had to curb her $500 monthly addition to her grandchildren’s college funds (her primary interest at this point).
4) Who stands to inherit the shares?
- Robert and his two sisters.
The key takeaway is that we don’t have a lot of flexibility to add value here. In an ideal world we could diversify away from this concentrated position by selling a portion of the stock over time. The single security risk is substantial, especially in the energy space, but we are largely handcuffed by Dottie’s low cost basis, lack of liquidity and her emotional attachment to the investments her husband worked for so many years to acquire.
So what are our options?
Well…..how about options?
Writing covered calls against this concentrated position may make a lot of sense here, provided both Robert and Dottie are adequately aware of the associated risks. But first of all, what does it mean to write covered calls against a concentrated position?
Selling covered calls (“covered” means you already own the stock) against a concentrated position (“concentrated” means a single security makes up a large portion of the overall portfolio) is a good way to generate income — i.e. You could earn $5,000 today by selling 100 contracts (100 contracts x 100 shares/contract = 10,000 shares) at a strike price of $128 that would expire at the end of June. Chevron stock trades around $124 today, which is its all-time high. This would be overly aggressive considering Dottie’s situation — a strike price of $128 is far too likely to be reached in the next few weeks, meaning the position would quite possibly be “called away” from Dottie (whereby triggering the tax consequence discussed above).
If we are willing to accept a slightly smaller amount of income, say $1,000-1,500 per month, we can significantly reduce the likelihood of Dottie’s shares being called away. In fact, it may be prudent to stagger out several different contracts (strike prices) so as not to put all of Dottie’s shares at risk at any given time. We can still improve on Dottie’s income by about 25% while minimizing – not eliminating – the degree of risk being taken.
Selling just 10 contracts at each of the ten strike prices between $130 and $139 would generate about $1,500 and would greatly reduce the risks of having any of Dottie’s shares called. And this could be repeated each month.
Understanding the Risks
The risks of which Dottie and Robert must be fully aware may be pretty clear at this point: If some or all of Dottie’s shares get called, she faces a tax bill. This is the primary risk in considering such a strategy.
But let’s not ignore the risk of doing nothing — there are no guarantees that Chevron stock will continue to perform well and/or that their dividend will be safe. I think the risks to Chevron’s dividend (currently 3.50%) are minimal compared with the risks to their stock price. It’s the dividend that matters most to Dottie, but — should a fraction of Dottie’s holding be sold — we can always reinvest the proceeds into other dividend-paying securities. And a little diversification never hurt anybody….
Have a great rest of your week!
Adam B. Scott
Argyle Capital Partners, LLC
10100 Santa Monica Blvd, #300
Los Angeles, CA 90067
Adam Scott’s profile on TheStreet.com can be found here.