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Since October I have been urging yield-oriented investors to combine the selection of good dividend stocks with covered calls. This system has been working very well, and readers have asked for more information about how to make these trades.

At the risk of giving away some information about our specific methods, I have decided to go into more detail. I hope that readers find it helpful in meeting their risk/reward objectives.

Background

The combination of dividends and call premium will yield 10% returns +/- whatever happens to the stock. If your time frame is a few years, and your stock picks are reasonable, you need only break even on the stocks to get a return that will solidly beat bonds and inflation. On a total return basis you can aim to double your portfolio in eight years or so, without getting unduly aggressive.

This is a sweet spot for many investors. You can do it, but it will take a little work. I have already covered several key topics in prior articles in this series. You will do best if you check out the past articles as well as this one. If you want this to work, don't cut corners!

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. Here is the chart I ran in my original dividend article:

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If the only idea you got from this article (November, 2010) was buying Caterpillar (CAT), you were in at 80.

Other stocks at the top of a pure yield screen might include companies about to cut the dividend since their payout ratio cannot be sustained by the earnings.

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.

Covered Calls

In my original article on selling options against your stock positions, I did not focus on dividend stocks. I did a careful description of stocks that fit the profile. Some stocks that I liked but were not suitable for covered writes (Apple, then trading around 318, was not suitable because we did not want to cap our upside. Other names were just fine, including my example of Noble Energy (NE) although I said the Microsoft was also a good candidate.

The article goes into some detail about sources and how to find the right call to sell.

Putting the Concepts Together

Last October I wrote about why investors should combine these two concepts to create a true total return, income portfolio. The basic idea is that you should not fixate on stock price movement. If you pick good stocks, collect dividends, and collect call premiums, you will achieve your target. Do not get too frisky on your stock selection!

I had an interesting section in this article, which I called, "Do You Qualify?"

Here is the qualification test -- hardly anyone can pass it!

You cannot look at your brokerage statement, the daily mark-to-market, the monthly mark-to-market, or anything else for ten years.

This is what you would do with a bond portfolio. You buy expecting to collect the coupon and the principal at maturity. It is a simple test, yet a difficult one. The bond investor does not worry about daily marks.

Psychologically, people cannot do this with stocks.

You should simply look at your statement and see if the combined flow from dividends and call sales are meeting the objective.

Implementation -- A Look Under the Hood

I am going to share some "secrets" about how we are implementing this program, including some recent actual trades.

Here are a few specific ideas that were not part of the prior articles. I am fussy about setting new positions. I do not mind holding cash for a bit while looking for the right opportunity. A good pick includes the following:

  • A stock that meets the dividend requirements described above.
  • A near-term option sale that would generate nearly 1% per month if the stock had no move.
  • A reasonable bid-ask spread on the option. I have the advantage of being able to split the market in many cases, but you can try the same thing if your broker permits spread orders.
  • An option sale that will compensate you fully if the stock is called away at expiration. This normally means that you get an immediate payoff of 2% or so plus the call premium if the stock rallies. You need a broker that does not soak you for an assignment on your short call.

I do not worry about losing stock positions in the current environment. There are plenty of candidates.

Examples

To illustrate, here are some trades that we actually did last week for this program.

Bought Abbott on March 6th (ABT) for 56.57 and sold the April 57.50 call for 57 cents. If the stock had done nothing, we would have collected a nice call premium as well as waiting for a dividend. Given the rally, we might just ring the cash register with a gain of 97 cents on the stock and 57 cents on the call premium -- almost 3% in about six weeks.

Bought Conoco on March 5th (COP) for 77.41 and sold the April 80 call for 94 cents. If the stock does nothing we again get a good premium. If it is called away on April expiration we make $2.59 on the stock and $0.94 on the call, for a total of $3.53 -- 5% in less than two months.

There are other similar trades.

This shows why we can afford to wait for good opportunities. I go shopping on days where the market declines sharply, offering good stock prices and high call premiums. My target is eight positions, but we sometimes have a smaller number when the market is not cooperating.

Conclusion

You can do this on your own if you have the right resources, the right broker, and watch the market closely. You must also be patient.

When options expiration comes, you may have some new decisions about whether to "roll" your short calls or look for new opportunities. I'll discuss this more in the next installment.

Disclosure: I still own the mentioned stocks -- AAPL, NE, and CAT -- as well as the specific option positions.

Source: The Quest For Yield (Part 6): Enhancing The Yield From Your Dividend Stocks