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Many investors are starving for income in today's low-rate environment. If you want more money from your portfolio, then you may want to consider some investing strategies you may not have ventured into before. That can be scary, but by looking at what professional investors have done, you can pick up valuable tips you can use in your own investing.
One strategy that's gaining in popularity is writing covered call options. Unlike some options strategies that can raise the risk in your portfolio substantially, covered calls essentially involve selling off a piece of the upside potential in your stocks for higher income. In fact, the strategy is successful enough that you can find institutional investors in the closed-end fund market who specialize in covered-call writing -- and by using particularly appropriate stocks, they've managed to produce double-digit yields in the process.
Covered call 101
Using the covered call strategy is simple. Taking stocks you already own, you sell options against your existing share holdings, giving the option buyer the right to buy your shares at a given price within a certain future time frame. The money you get paid for the option is yours to keep, and if the price of your stock stays below the strike price of the option, then you'll get to keep your shares. Only if your stock rises above that strike price will the buyer exercise the option, paying you the agreed price to take the shares off your hands.
Covered calls work with any number of stocks. The strategy can produce income from stocks that don't pay dividends and greatly increase total payouts for those that do pay dividends. But with so many different choices, it can be hard to figure out the best stocks to use the covered call strategy. For some guidance on that decision, one place to look is the world of closed-end funds: a special type of mutual fund whose shares trade like regular stock on public exchanges. By looking at covered call closed-ends, you can get a sneak peek into how professional investors are using the covered call strategy to generate huge amounts of income.
Putting it into practice
One closed-end fund that has turned covered calls into a gold mine of income is the BlackRock Global Opportunities Equity Trust (NYSE: BOE ) . By using covered calls, the fund has managed to sustain a distribution rate of 13%.
Which stocks has the Blackrock closed-end used to generate those gains? You'll find an interesting combination of promising stocks:
- The fund takes some high-dividend-yield stocks and amplifies their returns using covered calls. Royal Dutch Shell (NYSE: RDS-A ) , which pays nearly 5%, and the 7%-yielding Vodafone (Nasdaq: VOD ) are two great examples of how the fund tries to take big yields and make them even bigger.
- More typical midrange dividend stocks also find their way into the portfolio. IBM (NYSE: IBM ) and Arch Coal (NYSE: ACI ) both pay a bit less than 2% in dividend yield, but writing calls can boost those payouts.
- In many cases, the fund turns nondividend stocks into income producers with the covered call strategy. Apple (Nasdaq: AAPL ) and Google (Nasdaq: GOOG ) pay no dividends now despite their huge cash hoards, but covered calls can still produce income.
Now it's important to understand that distribution yields don't necessarily reflect actual returns for the fund. In 2010, the fund returned a little more than 10% despite its higher yield. Year to date, the fund is barely in the black.
Moreover, funds like these can sometimes simply return shareholder capital as distributions. That can be fine if the money represents unrealized capital gains, but it forces you to look more closely at these funds to make sure they're performing the way you want. Last year, return of capital represented about a quarter of the BlackRock fund's distributions.
Understand your options
The covered call strategy isn't risk-free. By owning shares, you still have the risk that they'll fall. And by writing calls, you won't get the full benefit of a stock making a fast move up. But for many, the added income is worth those risks. By focusing on smart stock picks for your covered call strategy, you'll improve your chances of strong returns.