Boost Your Dividend Income With Covered Calls: The Step-By-Step Guide

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Includes: KO, TGT
by: Sure Dividend

This post was written by Eli Inkrot for 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 (NYSE:KO) or PepsiCo (NYSE:PEP) or Procter & Gamble (NYSE: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 (NYSE:WMT) or other busy grocery store and find the shelves where your company's products are located.

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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?

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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 (NYSE:TGT).

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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, and forward guidance of adjusted earnings in the $5.20 to $5.40 range for 2016, shares are currently trading hands around 15 or 16 times expected earnings; which is more or less in line with the security's historical average.

As such, you might be quite content holding shares, watching growth formulate over the years and collecting a reasonable and increasing dividend.

Then again, the "current" yield sits at just 2.75% -- above your average S&P 500 (NYSEARCA:SPY) company but below many other dividend growth counterparts. Perhaps you'd like to receive more income.

In making this judgment, there's no reason to fret. You can both own shares in the company and generate a higher cash flow stream.

And by the way, I'm just using Target as an illustration, naturally any number of securities work for this exercise.

Let's See What Option Contracts Are Available

With options you have literally thousands of possibilities: different expirations, strike prices, combinations, you name it. But remember, we're keeping it simple.

Any basic brokerage account will have information on options, but not everyone uses the same one. As such, using basic public information can be a helpful reference point.

Yahoo Finance works pretty well as a place to gather information. If you can input a ticker symbol, you can get information on options. After entering "TGT" the basic summary page will come up. The third selection down is "Options." Here's what that looks like:

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When you click this link you'll be directed to Target's option page. Just above the tables you're able to select the expiration date that you would look. Below I have selected January 20th of 2017:

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Note that I have no affinity for this expiration date, but it will make the demonstration relatively straightforward.

The first tables list "call options." The second set are 'put options', which we'll leave for a later explanation.

The left-hand side starts with the strike price, followed by the contract name, last price, bid, ask and some information about that particular option:

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When you're looking at selling call options you're thinking about at what price you'd be happy to sell. Naturally this may be a new concept (as Warren Buffett would have it, "my favorite holding period is forever") but remember the underlying goal: to both own shares and increase your cash flow.

This is an individual process, but I'll pick a number to continue the demonstration. Owning shares of Target with a P/E ratio of 15 or 16 seems rather reasonable and you might be happy to hold at this valuation. Yet if shares traded around say 18 times earnings, you might not be as enthused. This would equate to a future price of about $95. We'll use that as our baseline: we're happy to hold, but also happy to sell should shares increase to $95.

If you wanted to make this agreement, you could sell the January 20th 2017 call option with a $95 strike price. In return for agreeing to sell at this price, you would receive a premium. As I write this the premium sits at $1.20. We'll call it $1.10 to account for fees and fluctuations.

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Option contracts are expressed on a "round lot" basis, or 100 shares. One contract is equal to making an agreement for 100 shares. So in this instance, you would receive ~$110 for agreeing to sell 100 shares of Target at $95 ($9,500 total) in the next 10 months.

Once you make the agreement, one of two things happens: either the option is exercised or it is not.

Let's look at the first possibility.

If shares continue to trade below $95 it's unlikely that the option will be exercised. (Why buy from you at $95 when someone can just go to the market and obtain shares for a lower price?) In this scenario, you keep your 100 shares of Target and continue to receive the dividend payments just as you normally would. The only difference is that you also received an "extra" ~$110 in upfront option premium.

You'd anticipate receiving say $225 (probably a bit more) in dividends to go along with $110 in option premium for a total cash flow of ~$335. This works out to a yield, based on today's price, of about 4%. You achieved your goal of supplementing your dividend cash flow and still get to hold your shares.

A lot of people like to point out that selling a call option does not prevent you from seeing a loss, which is true. However, if the option is not exercised your return will be enhanced. Regardless of whether the future share price is $70 or $90, you already received the upfront option premium. You're going to be $110 ahead if the option is not exercised.

Now let's think about the second possibility. If the share price goes above $95, the option will likely be exercised. Note that it doesn't have to be immediately exercised (or at all) but if the share price ends "in the money" it certainly will be.

In this case you still have your ~$110 in upfront option premium. You would receive a cash payment of $9,500 (less frictional expenses) for your 100 shares. In addition, you may collect some or all of the dividend payments for the year depending on when the option is exercised. In this scenario your total cash received will likely be somewhere between ~$9,610 and ~$9,835.

The risk here is that shares might jump to $100. In that case you're "stuck" selling at $95 when you could have simply held on to the shares and had a higher level of wealth. You might be kicking yourself in this scenario for having spent extra time thinking about how to "cap" your potential gain.

Yet I would contend that this is why you need to be happy with either side of the agreement. In this scenario your total return would be between 17.5% and 20.5% in less than 10 months. While it could be lower than what actually happens, it's not exactly a great tragedy either. If you could consistently earn this type of return you'd be on the fast track to substantial wealth creation.

This is why covered calls can be attractive. If you wouldn't be happy selling at any price, then naturally these sorts of agreements are not for you. Yet if you're looking for a bit of additional income, there are many options out there (literally) that can help to supplement your cash flow goals.

In this particular case you would either bump up your yield from 2.75% to 4%, or else see a total return in the 18% to 21% range in less than a year. If you're happy to hold shares in the first place, both scenarios appear quite reasonable in my view.

And naturally there are numerous other possibilities. This is just to give you an idea of the process. You can adjust the expiration date and strike price as you see fit. Perhaps you'd be happy to sell at $85, in which case your upfront income would be higher. Or perchance you'd like to make a shorter time commitment, as many investors do. The concept is that there is a great deal of flexibility associated with using options (they're aptly named).

To conclude this introduction, I'd like to go over some basic benefits and downsides associated with selling covered calls. Let's start with the good stuff.

Option Benefit #1: More Income

This one is obvious, but also the largest benefit. An agreement to sell at a certain price without a premium isn't call an option, it's called a limit order.

The benefit of selling a covered call is that you receive upfront cash flow once the agreement is made. That's yours to keep. Regardless of whether the option is exercised or not, regardless if the share price goes up 20% or down 20%, you receive immediate cash flow.

In the above example the added benefit is just over a 1%, but this amount can be much high depending upon the security, time frame and strike price.

Option Benefit #2: You Can Reinvest Right Away

Unlike dividend payments, which come in quarterly installments, you receive the option premium the moment you make the agreement. That's money available to you to that you can do whatever you choose. Time is on your side with those funds, as you're able to reinvest right away.

Option Benefit #3: The Downside Is Mitigated

If the option is not exercised, selling a covered call is always going to provide a higher return. In the above example for any share price between $0 and $95, you would have been better off because you would be ~$1.10 per share ahead of the "normal" situation of just holding.

That doesn't mean that your return must be positive, but it does indicate that any downside is mitigated and any upside (up to a $95 share price) is boosted.

Option Benefit #4: Allows You To Own Lower Yielding Securities

A lot of investors have minimum yield requirements when searching for a security. This makes sense if you need a certain amount of cash flow.

Yet it doesn't have to be entirely driven by dividends. Instead, you can look for the best businesses and then see what types of agreements are out there to supplement your dividend income. For that matter, a security doesn't even have to pay a dividend for you to be able to derive cash flow from owning it.

Those are the basic benefits, all of which stem from the premium you receive for making an agreement to sell at a price that you would be happy with.

Let's move on to some disadvantages.

Option Disadvantage #1: You Have To Work In "Round Lots"

Ordinarily share price does not matter, but with options it makes a difference. One contract is equal to 100 shares, or a "round lot." So if you want to sell a covered call you have to first own 100 shares.

For something like CSX (NYSE:CSX) that's a $2,600 commitment, definitely manageable. For something like Alphabet (NASDAQ:GOOG) owning 100 shares would mean a $70,000 commitment. That's a little less realistic for the average investor. Options can be limiting in this way.

Option Disadvantage #2: Options Can Cap Your Upside

The essence of a covered call is that you do better (return wise) when the option is not exercised, but you "cap your gain" when the option is exercised.

As illustrated above, if shares of Target jumped to $100 you would have put in this extra work to learn about options and figure out what agreement you would like only to do "worse" than a buy and hold investor. This is why it's so important to be content with the selling price that you agree to.

Option Disadvantage #3: Options Could Make It More Difficult To Own Shares In The Future

If you truly want to own shares in a company for the long-term there's no better way to do it than to simply… own shares.

Continuing with the Target example, if shares jumped to $100 you would have capped your gain and be forced to sell at $95. You might be happy with this agreement, but the share price bids could keep going up through the years never to return below $95 again. As such, it could become more difficult (i.e. you have to pay more) to "get back" those shares should you want to do so in the future.

Option Disadvantage #4: Have To Redeploy Capital

Personally this is the fun part for me, but for a lot of people they like to have a passive "set it and forget it" approach.

The likelihood of having to redeploy capital increases dramatically by selling covered calls. Naturally you have additional premiums to redeploy, but more pertinently your shares might be sold. This part is mitigated a bit by only agreeing to prices that you're happy with, but it remains that eventually you could have to figure out what to do with thousands of dollars at a time.

Option Disadvantage #5: Separate Tax Implications To Think About

Finally, there are tax implications to think about that go beyond a basic buy and hold strategy. For one, the option premium can be taxed at ordinary rates (short-term gain) instead of preferential rates as is often the case with qualified dividends.

Further, selling in the future could also trigger a taxable event. There are some somewhat complicated rules around various situations, but basically the likelihood of short-term gains increases.

This sounds like bad news, but I don't believe it should drive an investment decision. In the above example you might pay ordinary rates (but not necessarily) on the ~$110 option premium to start. This is in comparison to paying 0% and an extra $0; so it's all relative. From there, future tax implications depend on your cost basis of the security, length of time owned and whether or not the option is exercised. This too goes beyond the scope of an introduction, but the added complexity is nonetheless a downside for some investors.

Final Thoughts

That's the basic overview for becoming aware of selling covered calls. A lot of dividend investors focus on finding the best businesses, partnering with these companies at reasonable valuations and holding for years as the dividend income begins to stack up. This process can work quite well and indeed it is something that I have long advocated.

However, that's not to suggest that it's your only alternative.

If you'd like to both own shares of excellent businesses and derive more cash flow, here's a way to do so. By making an agreement to sell at a price that you're happy with you'll receive an upfront premium. Your total returns may be better or worse than simply holding shares, but the cash flow component is apt to be higher. The idea is to learn about the process and determine whether or not it might help you to achieve your investment goals.