I created this strategy to design an ongoing stream of monthly income from the dividend stocks held in my portfolio. Most of my high quality (5 stars) stocks only pay dividends on a quarterly basis. Therefore, I had to wait three months to get my dividend check. My solution was to add a monthly covered call to these stocks to enhance my income and to convert income to monthly payments.
This strategy was created to produce monthly income with stock dividends and covered call premium. In addition, there is a protective, blanket put, to ensure the volatility in the market does not affect your return of capital. This is how it works:
- Only use strong stocks as defensive plays. I categorize strong stocks as stocks with high quality or 5 star statuses that pay a dividend – preferably growing each year.
- Purchase stock in blocks of 100 shares. Then sell one call at-the-money (ATM) in the current month for every 100 shares you purchased. This creates 2 income streams: (1) monthly income from the covered call, and (2) stock dividends from each stock. Use this defensive strategy with more than one stock to diversify your portfolio.
- Buy a put to protect your capital. Look to purchase a slightly out-of-the-money put at least six months in the future. The put strike price will guarantee the price (floor) you can sell your stock at regardless how far its price might move down.
- To manage the trade, if the sold call expires worthless, then sell a new call in the next expiration month. If the call is exercised and your stock is called away, you can repurchase shares to sell new calls on. If you close the stock position and the bought put still has time left, you can sell the put for additional profits. If your stock price declines, you can sell more calls while keeping the put open or you can buy the call to close, sell the stock and sell the put. This works best in a non-taxable account as you do not have to worry about the wash rule. If you are using a taxable account, then when your stock is called away you can sell an ATM put for current month to get the stock put to you. The put selling also creates premium income for the investor.
- The value of the Blanket Put will increase when the stock price declines. This is how the Blanket Put protects your capital. You can close the entire position at any time you desire as you do not need to wait until expiration.
The rationale for buying a put that is 6 or more months in the future is so you can sell monthly calls for income without continuously adjusting or buying more puts. This will lower your commissions and protect the initial purchase price of the stock while you collect monthly premium income and stock dividends.
One stock to use for this strategy is Intel (NASDAQ:INTC). We will buy 100 shares of INTC at $23.00 per share for a total of $2,300. We will sell a January 2012 23 Call for $70. For protection, we will BUY a Jan 2013 20 Put for 225. This creates a price floor of $20 for our shares purchased at $23. INTC pays a quarterly dividend of $0.21 starting in Feb 2012 for this trade. We will continue to sell ATM calls each month for the entire year of 2012. We are assuming that the bought put will expire worthless. However, if you close the trade early, you will sell the 2013 put at market.
The results (comparable only) indicate a potentially 35% return. You will notice that this trade creates $840 in call premium and only $84 in dividends. The sold calls can significantly enhance your total returns on high quality stocks. And the protective put creates a $20 floor to sell your shares regardless if the INTC shares far below this price point.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.