Boost Your Dividend Income With Covered Calls: The Step-By-Step Guide by Eli Inkrot, Sure Dividend
The idea of dividend investing, and especially dividend growth investing, makes a lot of sense to me. Naturally there are numerous strategies out there that will work well, but there’s just something about receiving that quarterly payout that gets the investment juices flowing.
Even beyond the historical outperformance of dividend paying companies and aside from the idea that the best companies tend to be the ones increasing their payouts each year; there’s an “X factor” related to the process.
There’s something tangible and rewarding about owning a company like Coca-Cola (KO) or PepsiCo (PEP) or Procter & Gamble (PG).
If you’re ever feeling down about your blue-chip holdings, here’s an easy exercise to cheer you up: go into a Wal-Mart (WMT) or other busy grocery store and find the shelves where your company’s products are located.
Watch as people routinely chose to buy Coca-Cola or Bounty or Lay’s or Dasani instead of the generic product. I mean think about that last one. It’s just purified water. Yet over and over people are willing to pay a premium for the brand.
And you own a piece of that. Ticker symbols aren’t just an arrangement of letters sitting next to a blinking number. When you own shares in a company you have an honest claim on the underlying assets of the some of the largest and best companies in the world. If you owned enough shares you’d eventually control the business and could have Coca-Cola start selling “Joe’s Soda” or whatever you’d like.
Granted the vast majority of us will likely never get to that point (and you probably wouldn’t want to mess with “the real thing”) but it nonetheless underscores the point.
Better yet, the reward of ownership is proportional such that each share you own is just like a share that the founding family or CEO owns. The rewards, in this scenario, dividends and an underlying claim on future profits, flow to you consistently.
So nothing that I am about to say should take away from that…
The concept of owning pieces of excellent businesses that chose to pay you more each year is very much intact. However, I would like to offer some possibilities to supplement this process. There are a few alternatives out there, but for this article I’d like to highlight the idea of owning dividend paying companies and choosing to selectively sell covered calls as well.
This alternative addresses a very common scenario. Let’s imagine that you’re perfectly happy with your holdings, but you would like to derive a bit more income from your portfolio. The dividend cash flow that it provides is solid, but perhaps a bit shy of your goal or ambition.
You have some possibilities. For one you could elect to search for higher yielding securities. Of course you would want to continue to hold high quality businesses, so this endeavor may be limited.
Alternatively, you could choose to sell a portion of your holdings each year – say a percent or two – to add to the dividend income stream. This can work, but it also subjects you to the whims of outside market bids.
A third option (in this case literally) could be selling a covered call on one, a portion or all of your holdings.
So What Is A Covered Call?
Source: Option Monster
That’s a good question and I’m glad you asked. Options can get complicated, so let’s keep it simple.
A call option gives the buyer the right, but not the obligation, to purchase 100 shares of a security at some later date in the future. So if you hold a call option on say Coca-Cola with a $50 strike price and an expiration date in June, this means you can buy 100 shares of Coca-Cola for $5,000 anytime between now and the expiration date in June.
If the share price is above $50 this would be a good deal. By exercising the option, the call owner could buy something for $50 that might be trading hands at $52 or $55 in the open market. In this case the call option is said to be “in the money”.
Alternatively, if the share price is below $50 it’s “out of the money”. In this case there would be no incentive to exercise the option. Instead of buying shares at $50 the call owner could simply buy shares for a lower price in the open market.
The call seller is on the opposite end of the transaction. Instead of having the right to buy at a certain price, you have the obligation to sell 100 shares at that agreed upon price. So using the same example, if shares of Coca-Cola are trading above $50, you’re “stuck” selling at $50 regardless of what is available in the open market. Alternatively, if the price is below $50, the option is likely to expire unexercised and you do not have to sell your shares.
The reason that it is called a “covered” call option is because you own the underlying security. You can sell call options without owning the security, but we’re keeping it simple in this example. We’re only thinking about possibly using covered calls.
So why would anyone make such an agreement? You’re asking a lot of good questions today. The option seller receives a premium (read: upfront cash) for making this agreement. Should the option expire worthless, you keep the premium (Actually even if the option is exercised, you still keep the premium).
An Example of Covered Calls
Coca-Cola is always a dividend crowd favorite, but let’s select another security to make the demonstration clear. Let’s say that you own 100 shares of Target (TGT).
Source: Target Investor Relations
We’ll take a “bullseye view” for investors. Target is one those funky, cool stores that works to set itself apart. It still sells many of the same items as Wal-Mart, but it goes about it a fresher and cleaner way. I had a friend that called it the “$100 Store,” because everyone time they went in they ended up walking out with $100 worth of stuff.
The business history of the company has been quite solid. Over the past decade earnings-per-share have increased by about 6% annually. This was driven by a robust share repurchase program (with an average reduction of over 3% annually) to go along with reasonable revenue growth and a steady profit margin.
The dividend has been even more impressive – moving from around $0.40 back in 2005 to today’s mark of $2.24 (of course the payout ratio has subsequently increases as well). Just recently the company announced its 195th consecutive quarterly dividend payment (dating back to 1967) and Target has not only paid but also increased its payout for 44 consecutive years. It’d be fair to suggest that the company has been reasonably shareholder friendly over the years. Target’s long streak of dividend increases makes the company a Dividend Aristocrat.
Based on a share price around $82,