Before I begin the article, let me preface by saying that this is my first SA article (hopefully the first of many) and I'm writing about something I am truly interested in. I've experienced many highs and lows in only three years of trading in the stock market (I'm in my mid 20s) and recently I decided it was time to give up the wild ways (mainly because I experienced mostly lows) and truly invest in the market with a sound long term plan.
I'm not going to give you the details about why DRIP investing is a fantastic way to build your wealth long term. There are numerous articles, written by numerous Davids (Van Knapp and Crosetti to name a few), about the benefits. Further, there are a number of articles which highlight the benefits of implementing covered calls on your DRIP investments. What I'm trying to accomplish in this article is to highlight opportunities where you can not only make additional income on your DRIPs by using covered calls, but you can truly enhance that income on a very frequent basis.
Most articles I've seen about covered calls highlight an example that is very similar to this. You have a position in Walmart (WMT) (when I originally wrote this article, it was trading at $59.97) and you write calls that expire in September 2012 with a strike price of $62.50. The resulting premium is $1.10 per contract. What we're saying here is that we believe that in the next 5 months, Walmart will not appreciate 4.2%. The logic is definitely sound if you're bearish on the market, or if you believe Walmart will trade sideways for the next 2 quarters (that's a very realistic view in my opinion). But personally, 4.2% is too little of a buffer for me over that time period, and these options are written for a 5 month hold period which is almost half the year. That means realistically I can write two of these covered calls each year. Not to mention, in order to write 3 calls, if you bought Walmart today, you would need $18,000! That means annually you could expect $660 from these calls, which on the investment, yields you 3.7%.
Now consider this example:
Say you bought 300 shares of General Electric (GE) today (currently trading at $19.10) for a total cost of $5,730. You can write calls for May 2012 (only 1 month out) with a strike price of $20 and receive a premium of $0.25/contract. For this trade, you believe the stock will not appreciate 4.7% in the next month. Given the time period of about one month, this buffer seems a lot more reasonable. If you write 3 calls, you could make $75 bucks in a month (not considering commissions). What's great is that after they expire, you can write another 3 for the following month. It is very plausible that you could write anywhere from 6 to 12 of these in a year. Let's go with the middle number and say we did this 9 times in a year. The total income gained is $675, which results in a yield of 11.8%! Now of course, GE is much more volatile than Walmart and there is a very good chance your options could get exercised. In that case, it means you made 4.7% AND received the options premium in a very short time period. Not a bad return at all in less than 30 days.
Like I said earlier, I'm new at this and don't have too many details/flaws behind the benefits and drawbacks of this strategy. This was just a very crude example that was made to target the audience that wants to do covered calls on their DRIP investments, but while it's a little more risky (in terms of your stock being called away on a frequent basis), it can potentially yield higher returns (that all of us want).
Bear in mind I just started my own DRIP portfolio (with only about $10,000 total) and so I don't have enough shares to write any covered calls yet. But clearly that is where I'm heading. I highlighted GE because I currently own it and its share price is low enough that I could realistically buy more shares in the near future and begin writing calls on it relatively soon. Intel (NASDAQ:INTC) is another great example (I also own shares of this).
This article was not meant to criticize any other strategies or methods, especially when it comes to writing covered calls. I just wanted to write this article to highlight the potential for getting more income off certain DRIP investments. I believe Intel and GE are solid DRIP investments for the long term that provide solid call option premiums on a monthly basis. There are others I can think of, such as Caterpillar (CAT) and Mcdonald's (MCD) which also do, but because their share prices are so high, it will take some time before I obtain enough shares of them to use this strategy on them. I'd love to hear any other ideas, feedback, critiques, or suggestions as I start this process.