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In today's market environment, people are always looking for new ways to generate yield on their investments. Given the current state of the bond markets, that is a task that has become harder and harder. Many people have gone further out on the duration curve, or heightened their credit risk. Others have bought more and more dividend paying stocks.

In our opinion, both approaches have risk. Going further out and down in the bond market exposes investors, especially retirees, to unnecessary risk. And dividend-paying stocks still expose investors to company specific risk, to say nothing of their volatility. We believe there is a better alternative, and delve into our dividend "recipe" below.

Realty Income (NYSE:O) is a California-based REIT that does business across 49 states, with 137 different companies. Specifically, Realty Income engages in triple-net leases, a form of lease in which the tenant pays the rent, taxes, and maintenance fees. Since the company went public in 1994, it has dramatically outperformed the market, even with its simple and conservative business.

Click to enlarge image.

What makes Realty Income stand out from other REITs is the fact that it pays dividends each month, as opposed to quarterly. We believe that Realty Income had two reasons for adopting such an approach. The first is a matter of branding. Realty Income bills itself as "the monthly dividend company," and that sounds much more catchy than "the quarterly dividend company." The second is a matter of dividend reinvestment. Whether or not to reinvest dividends is a matter of personal preference. We, for example, reinvest our Realty Income dividends. In the long run, the fact that dividend are reinvested monthly instead of quarterly means that you will end up with more shares than if they were reinvested and compounded quarterly.

As of this writing, Realty Income pays out $0.146125 per share in monthly dividends, with its latest dividend increase occurring on June 19th. With Realty Income currently at $40.07, that represents an annualized yield of 4.376%. While that is certainly a respectable yield, we think it is possible to do better. And that is where options come into play.

Far too many investors view options as nothing more than reckless gambling. The truth is that when used properly, options can boost profits and mitigate risk. They may be used for speculative purposes, but so can common stocks.

We believe that a covered call strategy is ideal to enhance the yield one can receive on Realty Income. Specifically, we are looking at the December 22 $40 calls. While these calls may be in-the-money, they can be sold for a credit of $1.50, which makes it worthwhile to utilize them. We lay out the details of this trade below.

Realty Income Covered Call Trade
Dividends Received$0.87675
Options Premium$1.50
Less Strike Price Spread($0.07)
Total Income Generated$2.30675
Yield (As of 6/21/12)5.757%

The use of covered calls has allowed the possible yield rise from 4.376% to 5.757%. But that 5.757% yield is not annualized. It can be earned in just six months, because the covered call itself yields 3.569%.

Conclusions

When used properly, options can strengthen a portfolio in many ways, including raising the possible yield. With Realty Income, investors already own a piece of a safe, conservative REIT. And by adding covered calls, that yield can be increased even more. We believe that for investors seeking dividend income, this is a winning recipe.

Disclosure: I am long O.

Source: Combining Realty Income And Covered Calls For A Winning Dividend Recipe