Double (or Even Triple!) Your Payouts

I love investing in high-quality dividend stocks. The regular payouts from industry stalwarts. Income that multiplies year after year. The safety of relying on dividends rather than capital gains. About the only thing that would improve this kind of investing is fatter dividends. Oh sure, I love the dividend growth of the blue chips, whose yields can approach obscene levels over time. But I'd love a more lucrative payout now rather than later, all else equal.

I've found a surrogate for those fatter dividends by selectively using a specific type of option to generate bonus cash on my income-producing stocks. And it works especially well in tax-advantaged accounts.

It's easier than you think
Undoubtedly you've heard superinvestor Warren Buffett decry derivatives such as options as "weapons of mass financial destruction," but Buffett's complaint belies the fact that he himself has used them effectively. Correctly and Foolishly used, options can juice your income without the nasty side effects that the Oracle of Omaha so loathes.

Perhaps the safest option strategy is the covered call, which I've used to good effect.

I own the stock HRPT Properties (NYSE:HRP), a real estate investment trust that currently yields $0.48 per share, or 7.7%. That's a decent payout when compared to bank accounts -- or even many other dividend stocks, such as PepsiCo (NYSE:PEP) and Coca-Cola (NYSE:KO), both of which yield 2.8%.

After a nice run-up from the start of the year, I thought HRPT had careened about as high as it would go in the short term. In late September, the stock was trading near $8 per share -- near its 52-week high and more than triple its 52-week low. So I executed a covered-call strategy.

I sold calls on my entire HRPT position. That gave the options buyer the right to purchase my shares at the $7.50-per-share strike price. That would be profitable for the buyer if the stock closed above $7.50 by the options expiration date in November. In the meantime, the buyer paid me a premium of $0.70 per share for the privilege. In effect, I had agreed to sell the shares for $8.20 ($0.70 + $7.50), if the stock traded over $7.50 at the end of about two months. If the stock was below that level, I got to keep the premium and my entire position. And that's how I juiced my income.

Given its massive increase in the last year, I didn't think the stock would run much farther, and I was content to sell the stock at an effective $8.20 per share if it came to pass. But otherwise I would be happy to continue holding the stock and letting it shovel out its massive dividend.

By the time the options expired in November, the stock had declined below $7.50 per share. Therefore, I kept the premium and the stock, and I can repeat the strategy later if the opportunity becomes attractive again. Effectively, I earned more than a year's worth of dividend income ($0.70 premium vs the actual $0.48 dividend), and I have the opportunity to earn more.

Why it's safe
Covered calls are safe because you're exposed to no more downside risk than what you're already taking by owning the stock. You trade off some potential upside in exchange for the premium, but by selling a call at a relatively higher price, you can still capture some of the upside if the stock moves higher, as I've suggested in the table below.

Take a look at a few other large-cap opportunities that leverage the power of the covered call to increase your income. The table below shows the premium you would receive from selling the given option and how it compares to the dividend.

Data from Yahoo! Finance as of Dec. 9, 2009.

Why not boost those payouts through the power of options?

By writing covered calls on your Microsoft position, for instance, you get a premium of $0.87 per share. If you're still holding the stock at expiration, that premium more than doubles Mr. Softy's annual dividend, and you still get nearly 8% more capital gain if you have to sell the stock. If you want to be more aggressive with the covered call, you can trade off more premium now for a lower potential upside.

An underappreciated part of this strategy, too, is that it can work really well with the stocks of megacaps such as Johnson & Johnson and Kraft. Because these stocks move slowly, you have more opportunity to exploit the premium. 

Now, if you use this strategy, your stock will get called if it trades above the strike price at the expiration date, perhaps creating a taxable event. But by allowing some potential upside when you write your calls, you can mitigate this potentiality. And, as I mentioned earlier, if you write calls in a tax-advantaged account such as an IRA, then you can avoid tax consequences altogether. In that case, you get your premium, your stock gets sold, and you have cash for a new opportunity.

If income-juicing strategies such as this intrigue you, then let advisors Jeff Fischer and Jim Gillies at Motley Fool Options take your investing to the next level in 2010. Enter your email in the box below to receive your invitation!