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Dividend stocks have become quite popular with investors over the past few years. The low interest rates prevailing in most of the developed world have made fixed income investments much less attractive than they were prior to the financial crisis and the recession. In fact, many common stocks now have higher yields than the safest bonds. There are many stocks though that offer no or only a nominal dividend. The traditional method of generating income off of stocks like this is to sell off the position a little at a time while counting on capital gains to hold the value of the position steady. Unfortunately, the market has been stuck in a trading range for over a year now as illustrated by this one-year chart of the SPDR S&P 500 Trust (NYSEARCA:SPY).

Source: Fidelity Investments

This has made earning the capital gains needed to implement that strategy difficult. So, if you need to earn income off of your portfolio but still want to be invested in some of these stocks with little or no yield then what can you do? One solution is to use covered call options to create your own synthetic dividend.

As I have discussed in other articles, a call option is a derivative that gives the holder the right, but not the obligation, to purchase a specified stock at a specified price before or on a specified date. In exchange for this right, the buyer of the option will pay an initial sum of money called the option premium to the call option seller. If the owner of the option decides not to buy the stock from the seller by the specified date (called the maturity date) then the option will expire worthless and the seller gets to keep the option premium.

To create a synthetic dividend, you will need to be the seller of the option (called the option writer). The goal is to sell the option and have it expire worthless, thus allowing you to pocket the option premium. The option premium is the synthetic dividend. The synthetic dividend actually has a number of advantages over a "true" dividend like the one that you would get from a dividend paying stock:

  1. A synthetic dividend tends to have a substantially higher return than the yield on a regular dividend stock.
  2. The timing of the payouts is entirely in your control. You can adjust the strategy to receive synthetic dividends every month, every quarter, every year, or just about any other payment schedule that you would like.
  3. You have a certain degree of freedom with how large the synthetic dividend will be. It is important to remember that the larger the dividend, the greater the risk that the option will not expire worthless and you will have to sell the underlying stock.

The greatest risk when selling covered calls as a method to create synthetic dividends is the risk that the stock will be called away. This happens when the stock trades for higher than the specified selling price on the option (called the strike price). In that case, the writer of the call will have to sell their shares for the strike price. Since the goal with this strategy is to essentially turn a non-dividend paying stock into a dividend yielding one, this is the least desirable outcome.

One stock that is well-suited for this strategy is Atwood Oceanics, Inc. (NYSE:ATW). Atwood has not been a particularly exciting stock to hold year-to-date although there have been some fluctuations in the stock’s value. The stock has delivered modest capital gains over the last year, depending on when you purchased it. The 52-week low is $30.64 and the 52-week high is $48.84. The company currently trades near the top end of this range, closing at $44.55 yesterday.

Click to enlarge

Source: Fidelity Investments

Now, let’s have a look at how to use covered calls to earn a greater than 10% synthetic dividend yield off of this offshore drilling contractor.

This chart shows the prices for the January 2012 call options at various strike prices. For the purposes of this analysis, I have chosen to use options with a maturity date three months into the future to create a payment schedule similar to a quarterly dividend-paying stock. I urge you to decide what payment schedule works for you, should you decide to do this.

Click to enlarge

Source: Yahoo! Finance

The prices given above are per share of stock but each option contract itself is for 100 shares of stock. Therefore, to determine the amount that you will receive in premium, multiply the call option price in the table above by 100 and then multiply it again by the number of contracts that you wish to sell. You will need to own 100 shares of ATW for each contract that you write.

An Example to Illustrate

The best way to explain and illustrate how to profit using this strategy is with an example. For our purposes, we will assume that a hypothetical investor decides to sell 10 call options with a January 2012 maturity date and a strike price of $50. Obviously, selling the option with a $45 strike will result in more premium income but there is also a greater risk that the stock will be called away. That is a risk that the investor in this example wants to reduce. We will also assume that this investor bought his 1,000 shares of ATW stock at yesterday’s closing price of $44.55. Naturally, if you bought the stock for less than this then your yield on cost will be higher than what is shown in this example.

Therefore,

Cost of Stock (1,000 Shares of ATW): $44,550

Option Premium Received: $1,250

There are a few ways that this can ultimately play out at maturity.

Scenario 1: ATW Below $50 at Option Maturity

This is the outcome that is most preferred if an investor is using options to create a synthetic dividend on a stock that they wish to hold for the long-term. How do the returns look in this scenario?

In this case, the investor in our example keeps his stock. The buyer of the option will choose not to buy the stock for $50 (the option strike price) since ATW trades for less in the market. The investor that sold the call keeps the call premium as a synthetic dividend.

The total return in this scenario is 2.8% over a much less than three month period. If we assume that the investor can do this four times per year, then that would turn ATW into a stock yielding roughly 11.20% per year.

Scenario 2: ATW Above $50 at Options Maturity

This is the least desirable outcome from the perspective of our example investor but it is ultimately a very profitable outcome.

In this case, the investor in our example will have to sell his stock for $50 per share. The buyer of the option will choose to exercise it and buy the stock for less than the current market price. This will generate a capital gain of $5,450 for our example investor. Additionally, our example investor still gets to keep the option premium that was paid when the contract was sold.

This play thus produced $6700 in profit. This is a total return of 15.0% over less than three months. The annualized return is 119.2% (15% gain over 65 days).

Source: Atwood Oceanics: Use Options To Generate 10%-Plus Annual Synthetic Dividend Yields