These days, many investors are pulling out all the stops to pull as much income as they can from their investment portfolios. But with bonds and bank CDs paying very little, you have to ask your stock portfolio to work a little harder if you want to earn the income you're used to in more normal times.
The problem is that not all stocks pay dividends, and even the ones that do don't always give you all the income you need. But you don't have to give up hope if you need to get some extra income from your stocks. Using a simple options strategy involving covered call options, you can turn dividend tightwads into free-flowing streams of cash -- and squeeze even bigger payouts from stocks that already pay decent dividends.
The basics of the covered call
For many, options seem just like calculus or relativistic physics -- hard to understand and potentially hazardous to your mental health. But far from being intimidating or dangerous, covered calls are one of the easiest, lowest-risk strategies you can use.
Covered calls work like this: If you own 100 shares of stock, you sell one call option contract on that stock. The option gives the buyer the right to buy your stock at a set price at any time before the option expires. In exchange, you get an upfront payment called a premium. If the buyer decides not to exercise the option, nothing happens, and you keep the premium. But if the option gets exercised, you have to sell your shares at the agreed price -- although again, you keep the premium as a bonus.
Getting more cash
It's the premium that's the key to the covered call strategy, because it presents the extra income you can earn. Depending on which options you choose to sell, you can get a big income boost even on stocks that already pay dividends. For instance, take a look at how much you can increase the yield on the five biggest dividend payers in the Dow Industrials (INDEX: ^DJI ) :
|AT&T||29.15||March 2012 $35||0.52||7.7%|
|Verizon||38.05||March 2012 $40||0.48||6.5%|
|Merck (NYSE: MRK )||35.26||July 2012 $38||0.98||7.5%|
|Pfizer (NYSE: PFE )||19.84||June 2012 $21||0.84||8.3%|
|General Electric (NYSE: GE )||16.33||June 2012 $18||0.62||7.5%|
Source: Yahoo! Finance. Prices as of Dec. 5 close. *Effective yield = annual dividend plus option price, all divided by current stock price.
At the same time, you can do the same thing with popular stocks that pay no dividend at all. For instance, with Manitowoc (NYSE: MTW ) , June 2012 calls with an exercise price of $12.50 sell for $1.20 -- more than 10% of the current share price of $11.37. Writing July $35 calls on Westport Innovations (Nasdaq: WPRT ) or June $9 calls on Silvercorp Metals (NYSE: SVM ) would offer similar effective yields right now.
There's no such thing as a free lunch, even with covered calls. If shares soar above the exercise price of the option, then you'll have to sell your shares at the lower price, missing out on a potential home-run swing. But the thing to remember is that you get to pick the exercise price of the option when you choose to sell it -- so you can pick a price that you'd be comfortable selling your shares for no matter what, thereby locking in some extra income at the same time.
Covered calls give you an excellent way to make more income from your stocks. But it's not the only smart strategy you can use. Tomorrow, I'll take a look at how writing put options can let you get in on bargain stocks at the best price possible.
If you like the idea of options but aren't comfortable with your skill level on them, take a look at the Fool's "Options University." It's absolutely free but only available for a limited time, so just enter your email address in the box below to learn more about how options can fit into your portfolio.