Using Options to Generate Income in a High Yield Portfolio

Includes: CINF, ED, JNJ, KMB, STR, SYY, T
by: Scott's Investments

I regularly track a High Yield Dividend Champion portfolio. This month's update includes a purchase of MGE Energy (NASDAQ:MGEE) and Sysco (NYSE:SYY). Investors interested in generating income or hedging against a neutral can also use a variety of option strategies to enhance this, or any, portfolio.

Probably the most common option strategy is the covered call. This strategy entails writing (selling) a call option while at the same time owning an equivalent number of shares in the underlying stock. An investor who sells a covered call is selling the right to purchase shares in the underlying stock at a set price before a set date ("expiration date"). The investor selling the covered call increases his or her income by selling this right to another investor.

Selling covered calls is not without risk. There are two primary risks, the first is that shares in your stock are called away from you before expiration. An option can be exercised at any point and as long as you are short a call, you risk having your shares in the underlying stock being called away.

The second risk is that you lose potential capital gains. For example, assume stock XYZ is trading at $50 and you sold a $55 strike August call. XYZ comes out with blowout earnings tomorrow and skyrockets to $65. The holder of the call option you sold will most likely exercise the call at some point on or before expiration, assuming XYZ stays at $65. Your other option in this scenario would be to buy back the call at a hefty price, but you could then keep your underlying shares and "roll," or sell, a new covered call at a higher strike price.

Another important consideration is commission costs. Option commissions can vary widely among brokers and given that many options are often sold for less than $1/contract (or $100, representing 100 shares), it is important to understand the commissions and fees involved. It is also important to understand your broker's fees for option exercise or assignment. Finally, many options have little or no volume, a wide bid/ask spread, and sometimes no open interest (meaning there are no outstanding option contracts for the option in question). It is important to use the appropriate order type, such as a limit order, when dealing with options, most especially with thinly traded options.

There are numerous factors that affect option pricing and perhaps the most important is volatility. Stocks that investors anticipate having low volatility tend to have options that sell for low premiums. Who would pay a high premium for an out-of-the-money call if the stock price never moves? This presents a challenge for the Dividend Champion Portfolio as many of the underlying stocks tend to have lower volatility. Thus, it can be difficult to generate substantial income by selling out-of-the-money calls, especially if we pick expiration dates that are just a few months out. With that being said, below is an example of using covered calls to enhance income in the portfolio.

I used Born To Sell, a site specializing in covered call strategies, to quickly identify available options for the entire Dividend Champion portfolio. I prefer to use options that are closer to expiration (within the next 1-3 months) and those that are out of the money, which allows for the stock to have some capital appreciation before the strike price is hit.

This strategy can be most effectively employed if you believe a stock is a long-term hold but feel that it may have some short-term weakness or struggle to break through a specific price level. Selling calls on stocks in these situations allows you collect the option premium, collect dividends from the underlying stock as long as you hold the stock, and potentially hold the stock through expiration allowing you to repeat the covered call strategy for the next month. Another good entry point for selling a covered call is if you feel the overall equity market is due for a pullback, which could neutralize a stock you otherwise want to continue to hold.

Please note that MGEE and Community Trust Bankcorp (NASDAQ:CTBI) do not have options and so are not included in the example. Also, WGL has very little open interest so I have not included it in the example. Commissions, fees, and taxes are not accounted for in the data below:

Born To Sell Shares 7/7/11 Close Price Strike Expiration Option Bid Price as of 7/7/11 Income
CINF 300 29.39 30 08/20/11 0.3 $90
ED 200 54.04 55 08/20/11 0.35 $70
JNJ 100 67.92 70 08/20/11 0.43 $43
KMB 100 66.71 67.5 08/20/11 0.85 $85
STR 600 18.2 18 08/20/11 0.45 $270
SYY 300 31.55 32 08/20/11 0.5 $150
T 300 31.23 32 08/20/11 0.31 $93

For some excellent free information and more background on options, the Option Industry Council website is a great resource and provides substantially more information.

Disclosure: No positions in stocks or options mentioned.