Double Your Dividends With This Strategy

With interest rates at incredibly low levels, many investors are starving for income. Fortunately, dividend-paying stocks provide a consistent stream of income for their shareholders without ramping up the risk of your portfolio too far.

But if you're like many income-starved investors, even the healthy 2% to 4% yields you can get on many blue chips these days aren't enough to make ends meet. You'd really like something that can get you even more income from your stocks. Fortunately, there's an investing strategy that can help you get the income you need -- in some cases, even allowing you to double your income.

Show me the money!
The strategy I'll talk about today involves a tool that many investors never use: options. Many beginning investors are scared of options, because they're commonly associated with high risk. And it's true that if you use options unwisely, you can lose a lot of money in a hurry.

But just because you can use options to take on risky, highly levered positions doesn't mean that you have to use them that way. In fact, the simple method known as the covered call strategy actually reduces the risk of owning a stock -- while also giving you some extra income to boot.

Here's how it works: for every 100 shares you own of a particular stock, you sell one call option contract. By doing so, you give your option buyer the right to purchase those shares at a price and within a certain time that you specify. In exchange, the buyer pays you a premium -- and no matter what happens with the option, you get to keep that money.

Double your pleasure
You can use the covered call method on any stock that has options available. Many investors have used covered calls to turn non-dividend paying stocks into income-producing investments.

But for stocks that already pay dividends, covered calls boost your income even further. For instance, let's take a look at blue-chip stocks with market caps of $25 billion or more, and dividend yields between 2% and 4%, to see what covered calls can do to your income stream:

Stock

Dividend Yield

Option for Covered Call

Option Price

Total Annualized Income Yield*

Intel (Nasdaq: INTC  ) 3.3% September $25 0.20 7%
ConocoPhillips (NYSE: COP  ) 3.6% August $80 0.47 7.6%
Pfizer (NYSE: PFE  ) 3.8% September $23 0.20 7.7%
Target (NYSE: TGT  ) 2.1% October $55 0.35 4.3%
Freeport-McMoRan Copper & Gold (NYSE: FCX  ) 2% August $67 0.15 3.8%
3M (NYSE: MMM  ) 2.4% October $100 0.96 5.6%
Medtronic (NYSE: MDT  ) 2.3% August $44 0.15 4.6%

Source: Yahoo! Finance. Prices and yields as of June 6.
*Includes dividend yield plus annualized yield based on option premium divided by share price.

As you can see, you can tailor your covered call strategy to generate the income you need. By adjusting the strike price -- the price you're willing to accept for your shares -- and the date on which the option expires, you can increase or decrease the amount you'll get paid in premium when you sell the option.

The fine print
Now, you do give something up when you do covered calls. If the stock price rises above the strike price of the option, then the option buyer will exercise the option, and you'll be forced to sell your shares. But if you set the strike price above the current market price of the stock -- as the options listed above do -- then you'll guarantee yourself not just the premium you receive, but also some extra profit on top from share appreciation.

There's one other thing you have to be careful about with covered calls on dividend stocks: the possibility of early exercise. Usually, your option buyer will wait until close to the option's expiration date before making a final decision. But sometimes, it makes sense to exercise options on dividend-paying stocks early. If you want to avoid that, you'll need to keep a closer eye on when your stocks are set to pay their dividends.

But set up the right way, covered calls give investors the best of both worlds: You get extra income up front, plus the chance to participate in as much of the stock's upside as you choose.

Learn more
Covered calls are just one way that Jim Gillies and Jeff Fischer help their Motley Fool Options subscribers make money. With a 96.7% success rate on their trades, you won't want to miss what else they have to say. Just enter your email address in the box below, and you'll stay up-to-date on the latest money-making options strategies.

Fool contributor Dan Caplinger believes that making money isn't optional. He doesn't own shares of the companies mentioned above. The Motley Fool owns shares of Medtronic and Intel and has bought calls on Intel. Motley Fool newsletter services have recommended buying shares of Intel, 3M, and Pfizer, as well as creating a diagonal call position in Intel. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy gives you all the options.


Read/Post Comments (25) | Recommend This Article (71)

Comments from our Foolish Readers

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 June 06, 2011, at 4:38 PM, ratiotracker wrote:

    wow, this sounds like a great strategy, thanks so much for sharing

  • Report this Comment On June 06, 2011, at 5:35 PM, GregLoire wrote:

    Assuming that the people who are buying your options are acting rationally, this strategy won't actually increase your long-term average gains because the added income from selling premiums will be about the same as the money you'll miss out on when people exercise the options after your shares rise in value past the strike point.

    This strategy is great for lowering risk and providing more reliable income, but I think it's also important to emphasize that it's not creating free money out of nowhere. The cost comes from limiting your potential upside if a stock substantially rises in value.

  • Report this Comment On June 06, 2011, at 6:30 PM, augiefb wrote:

    You must add in the commission cost of an option. In the cast of one contract ($7.95 at Fidelity) for Intel the $20 premium is reduced by the $7.95 substantially reducing the effective dividend. So you need at least 1000 shares and the $200 premium is reduced by about $15. Better but still not so good.

  • Report this Comment On June 06, 2011, at 6:54 PM, MeTwit wrote:

    I am one of those who have always stayed away from options, not so much because of risk aversion but because my traditional broker believed I was an egg that needed to be held steady between two solid walls. They would not approve me to deal in options. Once I believed I had learned enough about covered calls and secured puts, they could not hold me much longer. I opened a new account at a more liberal brokerage, and within the last few months I feel so much better about holding shares in unkind times likes these of today.

    The question that haunts me is about taxes. How will IRS treat the dividends I have created myself? As short-term capital gains, or what?

  • Report this Comment On June 06, 2011, at 9:28 PM, TMFGalagan wrote:

    @GregLoire - You are absolutely correct that you give up potential upside in exchange for the premium. That's why it's important to tailor the strategy to choose option strike prices at which you're comfortable selling - that way, if those shares get called away, it'll happen at price levels at which you may well have thought about selling anyway.

    @augiefb - Commissions are also an important consideration, especially depending on how many shares of a stock you own. Commission rates on options vary widely; I've seen minimums of $1 or less at some brokers, while as you mention, others charge much more.

  • Report this Comment On June 06, 2011, at 9:35 PM, TMFGalagan wrote:

    @MeTwit - Taxes on options are extremely complicated; the answer to your question depends on a number of factors, including how long you hold the option, whether the option is eventually exercised, and whether the option is on an individual stock or a broader index. There are some circumstances in which received option premiums are treated the same way as short-term capital gains, but not always.

    best,

    dan (TMF Galagan)

  • Report this Comment On June 06, 2011, at 11:46 PM, Latinus wrote:

    Many years ago when INTC was trading above 70, I sold covered calls on INTC. The before those calls expired, I watched helplessly as INTC fell down to the

    twenties. That Is a risk that is not discussed on this thread.

  • Report this Comment On June 07, 2011, at 12:28 AM, Robinhardaway wrote:

    I do not get why anyone prefers taxable dividends to tax deferred capital gains. Need an income "stream"? Just sell off your appreciated stock and pay lower catalo gain rate. Is Buffet crazy to never pay dividends but just let the stock appreciate ? Puzzled.

  • Report this Comment On June 07, 2011, at 3:27 AM, GregLoire wrote:

    @ Robinhardaway -- The tax rate is the same for qualified dividends and long-term capital gains (15% max).

    You are correct that one could also achieve a revenue stream by selling appreciated stock, but this is more volatile, less stable/predictable, and will likely require additional transaction fees.

    Theoretically it shouldn't make a huge difference whether a company pays a dividend or reinvests that cash back into itself, but the former seems to have psychological benefit for people, and there may be limited opportunities for the latter.

  • Report this Comment On June 07, 2011, at 5:53 AM, dbtheonly wrote:

    Okay Dan,

    Let me ask the question Latinus hints at: having sold the call are you then foreclosed from selling the underlying stock in the event of a (precipitous) decline? Buying a comparable put would be massively expensive.

    There's got to be a reason 90% of the investors lose money in options.

  • Report this Comment On June 07, 2011, at 6:28 AM, hondamikesd wrote:

    @Latinus

    You run the risk of the stock's price significantly declining merely by owning the stock, not because of the covered calls. I don't see how covered calls change that equation at all, except lowering your cost basis and thus helping to cushion your losses.

    If you were required to keep those shares on hand (e.g. your broker required you to do so in order to sell the calls) then you could have bought to close those same $70 calls of INTC (at rock-bottom prices as the stock was plummeting) in order to close the call positions and then immediately afterwards sold the stock.

    If you weren't required to keep those shares on hand then you could have sold the shares off, which would have converted your covered call into a naked call. I doubt the party who bought your calls was going to exercise his extremely out of the money option to purchase INTC at $70 when it was trading in the twenties.

    As GregLoire points out, the risk that covered calls add to a long equity position is that of missed appreciation should the stock's price rise above the call's strike price. If you can live with that, on top of the brokerage fees for selling options, and the risk, if you're a small investor, of having an incredibly undiversified portfolio due to the requirement of having at least 100 shares (For nearly all option contracts=1 contract is a derivative of 100 shares) in order to write the covered calls, then by all means write away!

  • Report this Comment On June 07, 2011, at 7:25 AM, TMFGalagan wrote:

    @dbtheonly (and @Latinus) -

    Yes, a covered call doesn't do anything about the risk that your shares are going to fall. But you can always close the covered call by selling your shares and buying back the call you sold. If shares have fallen, then you'll typically be able to buy back the call for less than you paid for it. That's usually just a small profit even when the shares take a big loss, but it does prevent you from being locked into the covered call position.

    best,

    dan (TMF Galagan)

  • Report this Comment On June 07, 2011, at 8:59 AM, Florestani wrote:

    I must really be missing something here because I still cannot see, in the stock market, how anyone can make money unless someone else loses the same amount of money. These "options proponents" keep making it sound like you are just scimming money from some huge pool that otherwise will just stand there and stagnate. I've read, and re-read the various position papers and it sill seems to come down to betting on the direction a stock is going to go, and one of you wins when another loses. How exactly is this any different than any other transaction in the market?

  • Report this Comment On June 07, 2011, at 9:28 AM, TMFGalagan wrote:

    @Florestani -

    The way I see it, financial markets work because different investors have different views about the prospects for the investments they make. With options, the investors who buy the call options that covered-call users sell hope that the underlying stock will jump in price abruptly. Sometimes they're right and sometimes they're wrong, but both sets of investors can get value out of their positions -- even if only one eventually profits from them -- because they're presumably investing with different final objectives.

    best,

    dan (TMF Galagan)

  • Report this Comment On June 07, 2011, at 10:19 AM, wrenchbender57 wrote:

    dan (TMF Galagan), Your comment: "Taxes on options are extremely complicated" seems to bring up the point that trading options could also add additional fees from our CPA or tax guy at the end of the year. Most tax folks will charge more for anything that seems complicated to a non-tax person.

  • Report this Comment On June 07, 2011, at 10:48 AM, deckdawg wrote:

    I actually read an entire book on this strategy, and tried it for a while. It's not quite as easy as the book's examples led me to believe. Here are some of my observations:

    1.) Do it inside a tax advantaged account (covered calls are one of the few, (if not the only) option types you are allowed to use in an IRA. This eliminates all tax complications.

    2.) Make sure you want to spend a lot of time on something like this ... probably good for bored, retired folk.

    3.) You'll want to have a significant amount of money invested in the types of stocks that you would be interested in writing covered calls on ... otherwise the effort won't be worth your time.

    4.) Here's the big drawback, and the one that's not evident in the examples portrayed in the book I read - the price of the call is based on the market's expectation that the stock is going to rise in value rather quickly. Most of the types of dividend paying, stable stocks for which you might be interested in writing a call do not fall into this category. Therefore, the calls are very cheap. So, by the time you research it, pay your trading cost, etc., you might have better spent your time picking up pop bottles along the side of the road & returning them for the deposit.

    5.) Any good dividend stocks you own which has pricey covered calls should probably be held on to ... very likely they will rise in value.

    On the more positive side:,

    1.) If you are retired, and would be out playing golf if you weren't sitting home writing covered calls, then you will save a fair amount of money in greens fees, cart rental, beer, lunch, etc.

    2.) If you are retired and would be out walking, biking, swimming, gardening, etc., but instead are in your den writing covered calls, you will lessen your risk of getting skin cancer.

    I'm sure there must be some people who make some money doing this ... but it sounds easier than it is. (I know, having actually tried it)

  • Report this Comment On June 07, 2011, at 11:45 AM, liyuyi82828 wrote:

    Cover call miss the upside of the stock. In addition, cover call has above trading cost...

    To sum up, it will only make your broker rich, not you !!!

    No recommended..

  • Report this Comment On June 07, 2011, at 1:29 PM, fighter20 wrote:

    I used to like covered call strategy, until I missed an upside on Exxon Mobile.

    I had XOM few months back at 66.50 and I had intended to own it for rest of my life. I put covered call and stock went all the way down to 57. So far so good, I kept the covered call premium and still held stocks while taking dividends. However, I could not place other covered call because stock price was too low to earn decent premium on price I bought.

    Second covered call was also when stock rose all the way up to 77. I put covered call for 80 and stock went up to 87. My stocks were called away because of covered call.

    I learned my lesson - never place covered call unless you want to get out of that stock. It only works if you think stock is going to stay in that range.

  • Report this Comment On June 07, 2011, at 2:17 PM, TMFGalagan wrote:

    @wrenchbender57 - To clarify, for any particular situation, the tax rules aren't all that difficult to figure out. But you can't generalize for *all* situations because the rules vary.

    Also, the MF Options team has some very useful guidance on options taxation.

    best,

    dan (TMF Galagan)

  • Report this Comment On June 09, 2011, at 6:29 PM, whyaduck1128 wrote:

    @deckdawg--

    Money not spent on beer is not money saved.

    @wrenchbender57--

    As a tax preparer, I can tell you that the biggest factor in what I charge is TIME. Situations that look complicated to you aren't that complicated to me, not because I'm that smart, but because I deal with a given type of transaction so much more often than you as an individual. If you can organize your data and are able to explain what happened, your bill will be a lot smaller. If you force me to do your organizational work, such as matching transactions, researching stock costs, etc., you will pay more. This applies in particular to Schedules C, D, and E (self-employment, capital gains/losses, rental property).

  • Report this Comment On June 09, 2011, at 6:49 PM, whyaduck1128 wrote:

    I've been dabbling in options for the last six months, and while I've made a decent profit so far, obviously I'm still learning. However, I try to abide by a few rules--

    1. Never sell a naked call. Own the stock.

    2. Never buy a put. If I'm that pessimistic, I'll sell the stock.

    3. There is no shame in taking a modest profit. Buy back that sold put or call if the profit is substantial enough.

    4. Don't sell options priced under a dollar if you're only selling one. Transaction costs will eat too much of your profit.

    5. A little patience goes a long way. At least 40% of the time, my closed transactions would have been more profitable had I waited longer. (Yes, #3 and #5 are at odds, but both are true)

    6. If you're going to regret seeing a stock called or put to you, don't sell the call or put.

    7. If you're selling a covered call and the stock is still short-term for you, sell a call for a date by which it will be long-term. (I have a potential screw-up on this one, with PFE, should have gone a month longer)

    8. Don't mess with thinly-traded options.

    9. Just as with a stock, if you're uncomfortable with a move, don't make it.

    10. Pay attention to the underlying stock if you've sold a put on one you don't already own.

    11. Keep the transactions simple.

    12. If you're buying calls, use speculation money, not investment money.

  • Report this Comment On June 11, 2011, at 4:30 AM, optimist911 wrote:

    I've tried out this strategy in the past, making what I considered a decent profit -- at least until the stock shot up. Then my decent profit became paltry change compared to what I could've gotten by selling calls later. Later the stock came back down and is in the doldrums now, so it appears my shares won't be called away. My paltry change became decent profit again. I'm glad someone got value out of losing what they paid me for the calls.

  • Report this Comment On June 11, 2011, at 5:50 PM, UFOFred wrote:

    Hi All,

    Here's a few comments from a seasoned veteran (of 3 months and 4 contracts) <G>

    1. Figure a sell price and sell calls only if you can get a strike near that price. If you don't want to sell, then no calls. Likewise, if you want to dump a stock, just sell -- don't fool with calls.

    2. Calculate your return after commissions and your effective selling price if your stock is called away (including premium you keep and all commissions) It's helpful to develop a spreadsheet for this.

    3. Be careful of the tax complications for in-the-money calls on appreciated stocks. You could convert a long term gain to short-term.

    4. For tax info., see

    http://www.callwriter.com/newsletter/stock-option-tax-rules....

    http://www.twenty-first.com/newsletter/newsletter_spring2002...

    5. You do need a low-cost broker. I like Vanguard ($7 trading fee for regular stocks) but their options fee is outrageous ($30 + 1.50/contract).

    6. You can do options and still have a life. You need to do some homework but it need not consume all of your time.

    7. You can also sell puts on stocks you would like to buy. Similar rules -- if you **really** want to buy, don't fool with a put.

  • Report this Comment On June 13, 2011, at 10:13 PM, dolvlob wrote:

    This is a HORRIBLE idea. The author is proposing that someone who depends on dividends for income risk all of their dividends for a short-term gain.

  • Report this Comment On June 14, 2011, at 2:09 PM, pryan37bb wrote:

    I think people who find this strategy too 'risky' don't fully understand its possibilities. When you're selling a covered call, you set the price at which you'd be comfortable selling your position, if the stock should take off suddenly. For example, if you write a call that's 7% out of the money that expires in three months and you get called away, that's a pretty nice gain, especially if you write the call the day before the stock goes ex-dividend ensuring you also get the next payout. Additionally, some dividend stocks like AGNC and NPK have pretty predictable reactions to the stock going ex-dividend, so you can adjust your strategy accordingly to get more from the strategy.

    For people who worry that the stock will take off without them, my advice would be to not write a call until AFTER your stock has made a big upside move. For example, my VZ stock moved about 30% or so in only a few months, including the dividends. If you'd be comfortable locking in that profit, you could write a call closer to being in-the-money. Higher premium equals better downside protection, in case a high-flying stock runs out of steam (which my VZ did soon after). Likewise, if your stock tanks, you could write a put with the idea that if the stock falls a little more, you'd be okay adding to your position at that much lower level, lowering your cost basis, getting a higher yield, and collecting some premium of course.

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 1503643, ~/Articles/ArticleHandler.aspx, 11/23/2014 8:51:57 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement