One reason many ordinary investors turn to the Dow Jones Industrials (DJINDICES:^DJI) as a market benchmark is that the average is a fertile source for dividend-paying stocks. With all 30 stocks in the Dow paying a dividend, the Dow overall carries a yield of about 2.4%.
But if you're like many investors who are having trouble making ends meet living off their portfolio income, you might find 2.4% isn't enough to get you the cash you need. With a simple investing strategy that combines the use of the Dow-tracking SPDR Dow Jones Industrials (NYSEMKT:DIA) with call options, you can boost the amount of income you get from your portfolio -- and by a considerable amount in some cases.
It's your option
Many investors shy away from options, as they've heard just how volatile and risky options can be. Admittedly, there are plenty of situations in which using options the wrong way can cost you every single penny you spend on them.
But far from creating a high risk of loss, the income-boosting strategy I'll talk about today actually cuts your overall risk level. By using what are known as covered calls, you can trade some of the upside potential of a stock or ETF for guaranteed income that's yours to keep no matter what happens to its share price.
For Dow investors, the strategy involves buying the SPDR Dow ETF in 100-share increments, and then selling one call option contract for every 100 shares you own. The call option gives the buyer the right to buy your ETF shares from you at a price you select, at any time between now and the expiration date that you choose. In exchange for that option, the buyer pays you cash.
How much cash you get depends on the price at which you're willing to sell your ETF shares and how long you're willing to allow the option to remain effective. For instance, with the SPDR Dow ETF at around $154 per share, selling a call option expiring next Friday giving the buyer the right to buy your shares for $155 would only pay you about $0.30 per share -- or roughly 0.2%. Extend that option's expiration out to October, on the other hand, and the same option would pay you $2.33 per share, or 1.5% of your investment. That might not sound like much, but when you consider you can repeat the process every time the old option expires, the income can add up.
What's the catch?
Before you conclude that this looks like a free lunch, keep in mind that there is a trade-off. If the Dow ETF's price rises above the agreed-up strike price of the option, then your option-buyer will choose to purchase your ETF shares from you -- and the price you'll get will be less than the prevailing market price. In essence, what the covered call strategy does is allow you to trade some of your upside for guaranteed income. That said, the higher you set the option's strike price, the more upside you'll enjoy on top of the payment you receive for selling the option.
Still, by paying attention to the terms of the specific option terms you choose, you can often boost your total income by a substantial amount without taking away all your potential profits from further rises in the Dow. In some ways, covered calls let you have your cake and eat it too -- that is, you get extra income up front as well as the chance to participate in as much of the stock's upside as you choose.
Fool contributor Dan Caplinger has no position in any stocks mentioned. You can follow him on Twitter: @DanCaplinger. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.