During times of economic uncertainty, owning top-quality companies that pay safe and growing dividends is one way to ride out the storm. Dividends not only provide regular income to investors, but they keep management focused on creating steady shareholder value and deploying cash intelligently.
However, yields still average less than 2% for U.S. stocks, so dividends alone are not likely to propel your portfolio far into the black during topsy-turvy markets.
But if you add writing covered call options to large, dividend-paying stocks, you have a safe and celebrated strategy for creating both extra income and better returns.
Covered calls 101
When you own at least 100 shares of a stock that has options available on it, you may write (or sell) covered calls on your shares and be paid option income.
Here's how it works: Suppose you own 300 shares of Fool Me Once Inc. The stock trades at $30, and you'd be happy to sell your shares at $35. Looking at the options on the stock, you see that the $35 strike price call options expiring in three months bid $3 per share.
In other words, you're paid $3 per share when you write the call options, or $900 since you own 300 shares, and you're obligated to sell your shares if the stock price increases to $35 or above by the options expiration date. And then you wait.
If Fool Me Once Inc., is below $35 by the time your options expire, you simply keep the $900 and keep your stock. You've made income and can now write new covered calls if you wish. If the stock is above $35 by the option's expiration, your shares are called away from you (sold from your account) at $35. Adding the $3 per share that the options paid you, you obtained a net sell price of $38 -- more than you were willing to sell for.
The downside of covered call options is that, if the stock soars beyond your expectations, you may end up leaving money on the table. If Fool Me Once Inc. soars to $45 by the time the option expires, you'd still have to sell your shares at $35 for a total income of $38 per share. Missing extra upside is the main risk of covered calls, so the strategy is best for stocks you don't believe will suddenly take off.
With minimal risk, though, writing covered calls can pay 4% to 6% a year or more in extra annual income to your portfolio. Add that to a 2% dividend payment, and you're raking in some strong income before you even consider any share price appreciation.
5 stocks for income
So, which companies are good candidates for a covered call strategy right now? I ran a CAPS screen for four- and five-star stocks that pay at least a 2% yield, then went through the list and dug for some of the strongest among the bunch. These are large, leading companies that look reasonably priced and offer safe dividends. They're also stocks on which a Foolish investor seeking still more income can write covered call options.
Source: Motley Fool CAPS.
Allstate recently traded around $29.50. Its $32 call options expiring January 2012 were bidding $1.23 per share. If you bought the stock and sold the covered call, you would have a potential effective sell price on your shares in January of $33.23, or 13% above today's price in seven months.
Meanwhile, the covered call option itself pays you a 4.2% effective yield ($1.23 in an option payment divided by your $29.50 purchase price) over the next seven months. Over this same time, you'd also receive another 1.4% or so in dividend payments from Allstate, bringing your total potential income over seven months to 5.6%. That's rather tasty.
DuPont recently traded at $49.50. The $55 strike price call option for January 2012 was paying $1.59 per share. In this case, you would earn a 14% return in seven months if your stock is called away from you at $55. Plus, you would receive dividend payments. The call option, meanwhile, pays you an effective 3.2% yield in seven months ($1.59 divided by your $49.50 purchase price). Finally, if DuPont reaches January's option expiration below $55, you keep your shares, you keep the option income, and you can write new covered calls.
Make sure you're ready to sell
Writing covered calls for extra income is a reliable strategy, especially when used on strong stocks selling at reasonable prices. Covered call income can smooth out and pad your returns in up and down markets and can be generated steadily. Just make sure you're ready to sell a stock if it gets called away on you.
We're teaching about and using covered call strategies in a new free report from Motley Fool Options. We're also using other option strategies for income and better buy and sell prices on our stocks. If you would like to learn more, simply enter your email below.
This article was originally published Jan. 8, 2009. It has been updated.
Fool analyst Jeff Fischer owns none of the securities mentioned in this article. Motley Fool newsletter services have recommended buying shares of Emerson Electric. 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.