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:
Option for Covered Call
Total Annualized Income Yield*
Freeport-McMoRan Copper & Gold
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.
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.