“California Overnight Dividends”

By Travis Johnson, Stock Gumshoe, September 10, 2007

“Is it really possible to safely make $5,500 or more, in cash, in the next 24 hours?”

That’s how they open this teaser for a new investment newsletter from Stansberry and Associates, called Jeff Clark’s Advanced Income. And just as an aside, duh, of course you can safely make $5,500 or more in 24 hours … it all depends on how much you start with. If you’re starting with $10,000, then no way is it going to be “safe” …. if you’re starting with a milllion, probably it would be reasonably easy.

But on to brass tacks, this teaser is for the California Overnight Dividend, another piece of evidence that Stansberry at least has some clever copywriters who come up with interesting new names for investment strategies.

So is it real?

“And the best part is, this is not a one-time thing. You can continue collecting these payments as often as every single month… for as long as you chose.”

This is money that you keep, so we’re clearly not talking about unrealized stock gains here — it has to be at least somewhat comparable to a dividend.

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He gives a examples of these “California Overnight Dividends” that you could have recently collected:

Interoil (IOC): If you owned 1,000 shares, you could have pocketed a “dividend” of $3,500.

Crocs (CROX): If you owned 1,000 shares of this one, you could have gotten $5,500.

And Zumiez (ZUMZ): 1,000 shares would have gotten you a payment of $4,000.

That all sounds pretty good, right? Of course, none of these companies actually pay a dividend, so what on earth are we talking about?

“It’s often possible for you to collect “Overnight Dividends” six, eight, or even 12 times in a single year, using the same stock.”

They also give several examples for collecting these “overnight dividends” on Devon Energy, which you could have gotten many times through the last year or so.

Other clues?

These “dividends” are only available for “about 30%” of the companies in the market.

Throw in a few quotes from several investment gurus, including Richard Lehman, who wrote a recent book on this very topic, and the Gumshoe can lift the veil and tell you that this is a teaser for …

Well, not a particular stock, or fund, or anything like that. Makes the “reveal” a little less sexy, eh?

This is a teaser for selling covered call options as an income strategy.

For those who just said, “huh?”, you need to know a few things:

1, call options are contracts, traded every day on thousands of stocks, that give you the option of buying shares in a particular company at a particular price (the strike price) before a particular date (the expiration date).

2, call options often trade at a premium to the stock price, sometimes a very significant premium, even for near-term options.

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Here’s an example, using one of the companies in the teaser:

CROX has options available with a wide variety of strike prices — there’s one for October (which means it expires on the third Friday of October) at $55. With the regular CROX shares at $57 or so right now, you can tell immediately that this option is worth $2 a share. That’s the difference between the strike price and the current share price.

BUT, that particular option is trading for about $6 right now. So what’s that extra $4 for?

That’s what someone’s willing to pay to bet that CROX shares will go up sometime between now and the third Friday in October. Which implies that this person is betting that the shares will go up to at least $61, since that’s what it would take for the option to really be “worth” $6 on the expiration date.

Each option represents 100 shares, with some rare exceptions, so are you getting the flip side of what we’re talking about here?

That’s right — the California Overnight Dividend is what’s earned by people who SELL those call options.

So, in the case of the Interoil example given above, the shares are trading for about $33.50. You buy 1,000 shares of that, so not a small outlay at $33,500.

Then, you can sell up to 10 “covered” call options (“covered” means that you own the stock that you sell the options on, so you can uphold your end of the bargain without doing any risky betting or using lots of margin debt.) The 10 comes from remembering that each option is for 100 shares, so 10 options would represent 1,000 shares.

Now, when you sell those options (this does match the teaser, which came out before the market swooned on Friday), you get to pocket the money you get for selling them. So if you decide to sell a near term option for October, at slightly more than the stock price ($35, in this case), that was indeed going for about $3.50 a few days ago and you could pocket $3,500.

It’s also true that this is immediate, just like any other stock or option transaction, so you can certainly do it in 24 hours if you want to. No reason you have to, of course.

But there’s got to be a catch, right?

Well, of course.

You’ve sold your options at $35 for October in Interoil, so you’re essentially betting that the shares will NOT go above $35 before the expiration date of the option. Or at least, that they won’t go above $38.50 (the $35 strike price plus the $3.50 per share that you got for the option). If that’s how it works, you come out ahead.

If the share price stays the same for a month, you still get your $3,500. If it drops significantly, you’ve still got your $3,500 to ease the pain (though it gets tricky if it drops so badly that you want to sell it before the expiration date — since you’ve already sold someone the right to buy it from you, your broker might not like you to sell shares that you’ve already sold covered calls on).

But here’s the tricky part: If Interoil reports windfall earnings, or discovers a new oil well, or agrees to be bought out by a bigger company for a nice premium, you’re probably out of luck.

Let’s say the shares go to $50 before the expiration. You’ve still got your $3,500 for selling the call option, but the shares that should normally then be worth $50,000 thanks to this huge $50 per share windfall (remember, you’ve still got 1,000 shares), are actually only worth $35,000 to you.

That’s because, yes, you’re following along nicely, you already sold someone the right to buy all of your shares at $35. And now that the rest of the market thinks those shares are worth $50, the person who bought your call option will undoubtedly want to exercise that right, buy the shares from you for $35, and sell them immediately to someone else for $50.

That’s why people buy options — they’re betting that the price will go up.

And the folks who sell them those options — the people receving the “California Overnight Dividends” are hoping that the shares will stay more or less where they are, at least until the expiration date.

Now, it’s true that selling covered calls can be an excellent way to sort of scrape some income off the top of your portfolio without necessarily having to sell any shares (though there’s always that risk) — but it’s not always necessarily easy, and it does get rid of the booming upside that you occasionally see in stocks.

If you believe that the market is going to tread water or go down for a particular period of time, then selling off options on your stock positions is a reasonable way to get some income from positions that otherwise would sit in your portfolio and do you no good.

And, as teased, if you’re both right and lucky you can do it over and over — if the price of Interoil never goes above $35 before your expiration date, then you watch that date go by with glee as you just made $3,500 in free money. And you could then sell options on those same 1,000 shares again, since you still own the original shares — just choose a new expiration date and a new strike price and make your sale.

The two caveats I’d remember if trying to implement this strategy, whether you decide that you want to subscribe to a service that tries to coordinate it for you or you do it on your own, are:

A) You need to have pretty big positions in each stock — if you have just 100 shares, that’s only one option that you can sell, and the commissions for options, which are often higher than for stocks, will eat into your returns significantly. If you have less than 100 shares, you can’t sell even one option so this won’t work for you.

and B) You need to be very disciplined — you have to focus on this as a strategy for making short term income, and pick companies that you think have overly large option premiums but that you predict will not go up particularly quickly. If you’re like me, that situation when your stock doubles after you sold options on it is going to drive you batty, so I’d suggest going into this only after convincing yourself that you won’t be bothered by those lost opportunities and wi