5 Stocks for Strong Income

During times of economic uncertainty, owning top-quality companies that pay safe and growing dividends is one way to ride out the storm. Dividends not only provide regular income to investors, but also keep management focused on creating steady shareholder value and deploying cash intelligently.

Managers at firms such as Johnson & Johnson (NYSE: JNJ  ) and Lowe's (NYSE: LOW  ) take great pride in their record of increasing dividends every year for decades running. However, yields still average less than 3% for dividend-paying U.S. stocks, so dividends alone are not likely to propel your portfolio far into the black during topsy-turvy markets.

But if you add writing covered call options to large, dividend-paying stocks, you have a safe and celebrated strategy for creating both extra income and better returns.

Covered calls 101
When you own at least 100 shares of a stock that has options available on it, you may write (or sell) covered calls on your shares and be paid option income.

Here's how it works: Suppose you own 300 shares of Fool Me Once, Inc. The stock trades at $30, and you'd be happy to sell your shares at $35. Looking at the options on the stock, you see that the $35 strike price call options expiring in three months bid $3 per share.

In other words, you're paid $3 per share when you write the call options -- $900 total, since you own 300 shares -- and you're obligated to sell your shares if the stock price increases to $35 or above by the options expiration date. And then you wait.

If Fool Me Once, Inc., remains below $35 by the time your options expire, you simply keep the $900 and keep your stock. You've made income, and you can now write new covered calls if you wish. If the stock is above $35 by the option's expiration, your shares are called away from you (sold from your account) at $35. Adding the $3 per share that the options paid you, you obtained a net sell price of $38 -- more than you were willing to sell for.

The downside of covered call options: If the stock soars beyond your expectations, you may end up leaving money on the table. If Fool Me Once, Inc., soars to $45 by the time the option expires, you'd still have to sell your shares at $35, for a total income of $38 per share. Missing extra upside is the main risk of covered calls, so the strategy is best for stocks you don't believe will suddenly take off.

With minimal risk, though, writing covered calls can pay 4% to 6% a year, or more, in extra annual income to your portfolio. Add that to a 3% dividend payment, and you're raking in some strong income before you even consider any share price appreciation.

Five stocks for income
So which companies are good candidates for a covered call strategy right now? I ran a CAPS screen for four- and five-star stocks that pay at least a 3% yield, then went through the list and dug for some of the strongest among the bunch. These are large, leading companies that look reasonably priced and offer safe dividends. They're also stocks on which a Foolish investor seeking still more income can write covered call options.

Company

CAPS Rating (out of 5)

Dividend Yield

P/E

Chevron (NYSE: CVX  )

****

3.9%

6.7

Coca-Cola (NYSE: KO  )

****

3.3%

18.6

BHP Billiton (NYSE: BHP  )

****

2.7%

14.6

Merck (NYSE: MRK  )

****

5.1%

11.2

Spectra Energy (NYSE: SE  )

*****

5.6%

10.8

Data from Motley Fool CAPS and Yahoo! Finance.

Merck recently traded at $30. Its $32.50 call option expiring January 2010 was bidding $1.51 per share. If you bought the stock and sold the covered call, you would have a potential sell price on your shares in January of $34.01, or 13% above today's price in six months.

Meanwhile, the covered call option itself pays you a 5% effective yield ($1.51 per option payment, divided by your $30 purchase price) over the next six months. Over this same time, you'd also receive another 2.6% in dividend payments from Merck, bringing your total potential income over the six months to 7.6%. That's rather tasty.

Spectra Energy recently traded at $18. The $20 strike price call option for March 2010 was paying $0.80 per share. In this case, you would earn a 16% return in eight months if your stock is called away from you at $20. Plus, you would receive dividend payments. The call option, meanwhile, pays you an effective 4.4% yield in just six months ($0.80 divided by your $18 purchase price). Finally, if Spectra reaches March's option expiration below $20, you keep your shares, you keep the option income, and you can write new covered calls.

Make sure you're ready to sell
Writing covered calls for extra income is a reliable strategy, especially when used on strong stocks selling at reasonable prices. Covered call income can smooth out and pad your returns in up and down markets and can be generated steadily. Just make sure you're ready to sell a stock if it gets called away on you.

If you'd like to find out more about how to use options to make money in up, down, and sideways markets, check out our free video series -- just enter your email in the box below for access.

This article was originally published on Jan. 8, 2009. It has been updated.

Fool analyst Jeff Fischer owns none of the securities mentioned in this article. Johnson & Johnson, Coke, and Spectra Energy are Motley Fool Income Investor recommendations. Coke and Lowe's are Inside Value selections. The Fool has a disclosure policy.


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 17, 2009, at 2:53 PM, murakami7 wrote:

    Jeff,

    Great article. I have a question related to dividends and covered calls. If my only objective is to get the dividends without suffering the price decline of the stock on ex-dividend date, would the following work?

    Buy 100 shares of the stock that's paying the dividend the day before ex-dividend date and write a deep in the money covered call at the same time (with a delta as close to 1 as possible). On ex-dividend date, the stock and covered call should be a wash, right? Then you could sell both and just wait for the dividend payment.

    Would this actually work? Obviously you would need to find a stock (like HTS) that pays a high enough dividend or buy a large number of 100 share blocks to clear all commissions. The only thing I can think of that would not work with this strategy is you buy the stock but can't write a deep enough in the money covered call to create the wash effect the next day.

    Thanks,

    Lance

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