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This article is part of our series on options investing, in which The Motley Fool is sharing a number of strategies you can use to get better results from your investment portfolio.
Lots of investors -- and I'm one of them -- love big sturdy dividend stocks, but let's face it: Compared to some other stocks, they're kind of boring.
Now, that's not necessarily a bad thing. When markets are choppy and economic worries are rising, "boring" can be a beautiful thing. Big recession-resistant stocks that pay solid dividends don't rise all that fast when the market's hot, but they also don't crash as hard when things go wrong. And up or down, that dividend keeps giving you some profits you can (usually) count on.
But it's also true that the dividend yields on these kinds of stocks don't tend to be all that impressive in the grand scheme of things. Kleenex king Kimberly-Clark (NYSE: KMB ) is one of my favorite recession-fighting stocks, but its 4% dividend isn't enough to power the retirement of my (or your) dreams all by itself.
But what if we could double that dividend using a simple options strategy?
A low-risk options strategy to boost your returns
Options strategies can be dauntingly complex, but fear not: The options technique known as writing covered calls is one of the simplest and lowest-risk ways to use options. It's a great strategy for boosting profits on those slow-moving dividend stocks we love to hold in uncertain times. And it's simple enough that you'll have no trouble understanding it, even if you've never used options before.
Even the lingo is simple: When we "write" a "covered call," we sell someone the right to buy (or "call") a specific stock at a specific price on or before a specific date. The word "covered" means that the stock in question is one we own, and that makes it a relatively low-risk strategy.
The essence of the strategy is this: We're making a little extra money every few months by selling someone the right to buy our stock at a price that it probably won't reach before the option expires. Over the course of a year, this can give our returns a big boost -- sometimes even doubling the stock's dividend yield -- without adding downside risk.
Let's take a look at how this works.
Selling options for fun and profit
First, we choose a stock, preferably one that fits the description above -- solid, sturdy, slow-moving, ideally with a good dividend. Recession-resistant consumer staples companies are great choices; soap behemoth Procter & Gamble (NYSE: PG ) , ketchup giant (and dividend dynamo) H.J. Heinz (NYSE: HNZ ) , and canned-soup leader Campbell Soup (NYSE: CPB ) are three worthy examples.
But other stocks that behave similarly, like global package giant United Parcel Service (NYSE: UPS ) , would work well. You could also try a cyclical stock like Dow Chemical (NYSE: DOW ) or Ford (NYSE: F ) , but be careful: Cyclicals can move sharply when the economic winds change direction, and that can mess up our strategy.
For the sake of our example, let's say that you've bought 200 shares of UPS at $66. You think it'll go up over the long term, but you don't think it'll go too far in the next few months -- probably not over $75. As I write this, the market will pay you $0.73 a share for calls that give someone the right to buy your shares at $75 between now and mid-January, so selling two of those calls (each covers 100 shares) would put $146 in your account right away.
How could this play out? There are only three possible scenarios:
- The stock goes way up. Here's where the risk of the strategy is. UPS might go to $90, but you'll end up selling at $75 when those calls get exercised. Still, you'll have made $9 a share, plus $0.73 for the call. That's nearly 15% on a stock you held for only a few months. As consolation prizes go, that's not bad -- and dividends could add more to the total.
- The stock goes way down. Well, that's a risk with any stock. But you still made that $0.73 a share, and you can write a fresh batch of covered calls in January.
- The stock price doesn't change much. Congratulations! You held a stable investment during a time of market uncertainty, and you collected an options payment and maybe some dividends.
As you can see, the "risk" added by selling the options is that it limits your profits, not that it exposes you to additional losses. But if you did this three times a year, you'd add more than 3% to your profits. Combine that with UPS' 3.1% dividend, and that's a pretty decent return on a "boring" stock during tough market conditions.
Stay tuned throughout our options investing series and get the strategies you need to earn more from your investments. Click back to the series intro for links to the entire series.