Using Covered Calls To Increase Your Yield: Gravy For A Dividend Growth Portfolio

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 |  Includes: POT
by: Michael Thomas

For those of you who have never dealt with options before, the idea of using a covered call on a stock position you own may seem like a foreign concept. Let's first explain what an option is. In the most basic sense an option either gives you the right to buy ("call") or sell ("put") an equity at a determined strike price within a certain period of time.

Options chains are displayed on just about every financial quoting website out there such as Yahoo and CNBC. An options chain displays the current ask/bid prices for options at different expiration dates and strike prices.

Let's take an example. Looking at the options chain for McDonald's (NYSE:MCD), we can see that the Jun 12 $92.50 call option's ask price is at $89 at the time of writing. If you were to buy this option it would cost you $89 plus commissions. Owning this option gives you the right to buy shares of MCD at $92.50 at any time before or on the third Friday of June 2012. Say MCD goes up to $100 the first week of June. You can exercise your option and buy the shares at $92.50 even though they are trading at $100. You'll have an immediate gain of $7.50.

Many traders use options for leverage. You essentially control 100 shares of an underlying equity for a fraction of the cost. If someone were to believe a short-term spike in the price of MCD stock that person could buy shares outright on the market at say $92 a share. Or the person could buy call options for MCD and control a much larger quantity of MCD stock for a fraction of the capital required for the position.

There are numerous ways to trade options and if you are interested I suggest you get a good book because it can get complicated in a hurry. For now, though, we are only interested in selling call options on positions we own in our long-term growth portfolio.

A covered call option is an option that is "covered" by owning 100 shares of the underlying equity. It is considered covered because we already own the shares and if the call option is exercised there shouldn't be any problem in delivering those shares to the owner of the call option.

Selling covered call options is a great way to increase returns and supply a little more capital through selling to buy more stock in great dividend growth companies. Let's take another example.

Say you own 200 shares of Potash Corporation of Saskatchewan Inc. (NYSE:POT) at an average price of $39. We could sell 2 x July 12 $43 call options at the bid price at the time of this writing of $81. We would immediately pocket $162 minus commissions that we get to keep. That's 2.08% return for about a two-month period or an extra 12% annually if you could pull it off 6 times in a year. A couple of different outcomes can happen now. The price of POT goes above the $43 strike price and the call is exercised. If this happens you get a decent capital gain of $800 plus the $162 premium you got from selling the calls. Now, we as long-term investors don't necessarily want to sell our shares. We could at any time buy back the options we sold, possibly at a loss, to prevent having to sell our shares. The other outcome is the price of POT stays below $43 before expiring on the third Friday of July. The option expires worthless, you keep your 100 shares of POT, and get $162 in covered call premium for your trouble.

Given the example, you can start to understand how covered calls can provide a steady stream of capital to help finance additional dividend growth stock positions. It's not without risks however. You have to be willing to sell your shares and you need to understand how writing covered calls can affect your qualified dividend status as well as your stock holding period that is used for long- or short-term capital gains tax. In short, as long as you sell out of the money calls with more than 30 days to expiration but less than a year to expiration, the covered call positions should not impact either your holding time for determining long- versus short-term capital gains or your qualified dividend status on the underlying shares. An out of the money call option is an option with a strike price higher than the current share price of the underlying shares.

Disclosure: I am long MCD, POT.