Use This Trick to Double Your Dividends

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.

Fool contributor John Rosevear owns shares of Ford, but has no position in the other companies mentioned. The Motley Fool owns shares of Ford and United Parcel Service. Motley Fool newsletter services have recommended buying shares of Procter & Gamble, Kimberly-Clark, Ford, and H.J. Heinz. Try any of our Foolish newsletter services free for 30 days. 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 Motley Fool has a disclosure policy.


Read/Post Comments (9) | Recommend This Article (12)

Comments from our Foolish Readers

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  • Report this Comment On September 20, 2011, at 1:18 PM, adamj980 wrote:

    I agree. I do this on all my dividend paying stocks in my retirement account. I sell them every month. Sometimes I lose the stock and a bit of potential profit but I usually just buy the stock back and go back to selling. I like the idea of capturing the definite money every month.

  • Report this Comment On September 20, 2011, at 2:09 PM, mikef445 wrote:

    John,

    Great article. I use this strategy all the time. The worst that will happen is that you get taken, and lose some upside. You gotta look at it this way. It's like getting your money refunded to you with a nice bonus.

    I even use this strategy to offset dividends I would've collected on my cash position.

  • Report this Comment On September 20, 2011, at 6:10 PM, memoandstitch wrote:

    How do you compare selling covered calls to selling put options?

    They both seem to have a similar risk profile but selling put requires less capital.

  • Report this Comment On September 20, 2011, at 6:34 PM, hbofbyu wrote:

    Betting against your own portfolio in terms of covered call selling seems counterintuitive.

    Shouldn't it be emphasized that if your stock takes a dive, you have to ride it to the bottom? (Like when I owned BP)

  • Report this Comment On September 20, 2011, at 8:54 PM, TMFMarlowe wrote:

    @hbofbyu: If the stock really blew up (like BP did), why would you "ride it to the bottom" when you could just buy back the now-worthless calls for a few bucks and close the position?

    John Rosevear

  • Report this Comment On September 20, 2011, at 8:58 PM, PostScience wrote:

    What about trading costs? Bid-ask spreads are quite large on many options contracts.

  • Report this Comment On September 21, 2011, at 3:42 PM, chadscards1274 wrote:

    Couple of clarifications. First, writing a covered call isn't necessarily betting against your own portfolio. For instance during the bull run of early 2009 - 2010 you could have bought and held and written increasingly higher covered call prices on several stocks (AFL and F) being two prime examples. The key is you have to know what you expect from the company.

    Second, "having to ride the stock to the bottom" means you get to keep the covered call option income, plus you still own the stock and in BP's case this was actually an excellent opportunity to buy more once it hit the floor and write covered calls on these new shares. At one point BP's covered calls that were near the money were paying 7-10% up front!

    Last, where trading costs are concerned I suggest calculating (I use Excel) what the commission costs are for each step. The commission to buy the stock, the write the covered call and then don't forget any commission if the call option is exercised. In the article's suggestion using the broker I use Scottrade you would pay $7 to buy the shares, $7 + $1.25 per contract (so in this case $9.50) to write the 2 options. So instead of the $146 mentioned above you would get more like $136.50. The cost if "the stock goes way up" and the option is exercised and the stock is sold is $17 so you would have to take that $17 off whatever capital gain you would otherwise have made.

    Oh and one more thing, don't forget taxes, covered calls are usually short term trades (less then 12 months) and normally are treated at short term capital gains so don't forget that if you write these calls you should be reporting any income to Uncle Sam.

  • Report this Comment On September 22, 2011, at 6:54 PM, memoandstitch wrote:

    Yeah, bid-ask spread is a deal-breaker for many stocks. This is the reason selling a put option is more attractive because it requires only one trade, instead of two (which causes a lot of uncertainty when bid-ask spread is wide).

  • Report this Comment On September 24, 2011, at 12:08 AM, HughWillFool wrote:

    This article is about writing "out-of-the money" calls - at a strike price you judge is unlikely to be reached - for "big, solid, sturdy, slow-moving, ... recession-resistant stocks that pay solid dividends [and] don't rise all that fast when the market's hot".

    hbofbyu wrote "Betting against your own portfolio in terms of covered call selling seems counterintuitive".

    But how are you "betting against it" when you've intentionally built your portfolio to be stable, and the call only pays off to the buyer if your portfolio doesn't perform the way it was designed to do?

    Consider that when you carefully built your conservative portfolio so that it wouldn't run away (to the downside, of course), you've also assured that it shouldn't run away to the upside either.

    What you're actually betting that your portfolio will perform as you have designed it to do.

    And the particular call you decide to write, (as in the example above), is carefully chosen to be at a "strike" price far enough above the stock's current price as to be , by design, unlikely to be reached.

    In this way, you can expect to write a repeating series of calls against the same underlying stock, making a little on each one, and rarely, if ever, seeing one of them actually finish out its brief life "in the money".

    So what you're really betting here is that the call's buyer will end up a loser, and you, the writer, will come out ahead.

    Whenever a call is written, it initially has a "time value" that constantly erodes until the call's life is up.

    That "time value" is what you are attempting to add to your portfolio's income, by writing an appropriately chosen covered call against your owned stocks.

    The closer the strike price is to the stock's current price, and the longer the time you write the call for, the higher the price you get for the call, and the higher the risk that it will end up in the money.

    And you as the writer get to choose how close you want to play it.

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