In the last few weeks, nearly every income-oriented strategy has crashed. Investors who need reasonable yield have chased all of the usual suspects. The result?
Yield-oriented investments are no longer safe. They have become both expensive and risky.
Investors in some bond funds are about to learn that they can lose more than a year's worth of yield in a single month. The bond investor is not accustomed to losses. The story is playing out in REITs, MLPs, and utilities. Even the "all-weather" funds created by the best and the brightest have fallen on hard times. Tom Brakke's special chart style captures what has happened to risk parity funds:
Is there anything left for the yield investor? Yes - if you are willing to do some work.
Combining Two Methods: Dividend Stocks and Covered Writes
In my Yield Quest series, the most popular work I have ever done, I discussed overall strategy as well as the most important income approaches. (See a summary of the entire series, with links. Many of the warnings have now played out, but one strategy has been a shining success: The Enhanced Yield approach discussed in Part 6. I invented this approach to meet the long-term needs of income investors. My initial article was based upon the first few successful months. I have received a number of requests from investors who want to try this method. Fair enough! Let me try to help.
We now have nearly two years of experience with the program, including some market corrections. I am prepared to share that experience, but let us first review the strategy, hitting the highlights from the original article.
Picking Dividend Stocks
A great dividend stock must first be a great stock!
Too many investors just screen for high yield. Many of these stocks trade as a function of the yield. It is like buying a 100-year bond. If you think that bond yields are going higher, these stock prices will go lower.
When I am picking stocks I get ideas from many sources. With ideas in mind, my most important screen is earnings-based, since that will eventually determine price. I am a big fan of Chuck Carnevale's service, where you can get a long-term earnings history as well as many important metrics for stock valuation. I do not take any long-term investment position without "talking to Chuck" via his site. Even if you are not a subscriber (and you should be), Chuck graciously shares many of his best ideas and screens with a complete suite of charts.
So we now have a list of stocks with reasonable, well-supported dividends.
Since I wrote the original article, two things have happened:
- Chuck's service has gotten even better! You can now customize for your own PE multiple and adjust the dividend charting.
- Seeking Alpha is much, much stronger on dividend recommendations. There are many good sources which I follow. You can start with the dividend investor link.
Choosing the Right Call
There is no exact formula for choosing the right call to sell. Here are some rules that have worked:
- Look for a call sale that creates an annualized yield of over 10%. You can fudge a little if the dividend yield is strong.
- Stick to calls that are out of the money - maybe by 1 - 3%. If the stock rallies and is called away (and you do not collect a dividend) you want compensation.
- Stick to the "front months." The key to success is capturing the rapid time decay of options in the last seven weeks of life. Those selling longer calls are not working hard for results. They are like the late-night "set it and forget it" TV guy. If you want to earn 8-10% you have to work every month.
Managing the Position
Getting the most from this strategy means taking what the market is giving you. You cannot be blinded by headlines. The market fluctuations give you a chance to add positions at great prices. The key week is right after options expiration. You will typically find that some of your sold options have expired worthless and some of your stock has been called away. How should you trade this?
While many were fuming about "Uncle Ben" we just looked for opportunities. Here are two examples:
- Down day. Look for new positions. Down days are great for buying stock and selling calls that are "pumped" with the increase in volatility. We bought INTC at 23.65 and sold the JUL 24 call for 54 cents. Intel rebounded to 24. If it stays there or higher, we'll make 4% on the position in a few weeks.
- Up day. We waited patiently for a rebound in stocks where calls went out worthless. We sold calls in XOM and COP at good prices.
These are tactical examples, but completely typical of trading each month. There are short-term winners and losers on stock price, but the stream of dividends and call premiums meets the yield objective.
Any investment balances risk and reward. Most of the yield plays have proven to have excessive risk. I favor the enhanced yield approach for the following reasons:
- The selected stocks are very solid. Many experts would recommend these for a portfolio that was better than holding bonds, even without the call sales.
- It is actively managed, always finding the best current opportunities. If you lose one stock, you just move on.
- You have a good cushion from the call sales. While the investor should focus on the long term, I track the daily results. The risk has been much lower.
- You can join me in monitoring and reducing risk.
- Back off in times of uncertainty. I reduced positions to half size during the fiscal cliff debate at year's end, even though I predicted a successful resolution. Risk considerations come first!
- Monitor actual recession odds - the ones I monitor each week - not those who are in permanent recession mode.
- Monitor financial risk. This is what happened in 2008 -- reflected in various credit spreads. We now have the St. Louis Financial Stress Index to help us. Just read my regular WTWA series to follow this.
How well can you do with this program? I have some significant advantages over the individual investor and I am not allowed to advertise results. My team is always following the markets and we have possible trades queued up for our entire group. We can sometimes get good pricing for investors since they are part of a larger group. (The guys in the pit will not respect your "two lot"!) We also have proven methods for stock and option selection.
Allowing for all of this, I expect that a hard-working, intelligent, and courageous investor can clear 8-9%.
- Make sure that your broker has low options commissions and favorable treatment on "assignments."
- Do this in an IRA since the gains are mostly short-term.
- Keep your focus long-term. If you break even on the selected stocks, you will meet your target.
- And take what the market is giving you!!
If you are worried about a sideways or slightly-declining market, this strategy will work well.