An income investing strategy, espoused often on Seeking Alpha, is for an investor to enhance a stock's returns by "doubling the dividend." This is done by buying a dividend paying stock, and selling covered calls on the stock. By selling calls every month, the investor can earn a significant amount of income through the course of a year, often even more than the stock pays in dividends. Companies commonly suggested for this strategy include: McDonald's (MCD), Exxon Mobil (XOM), Wal-Mart (WMT), Walgreen (WAG), and 3M Company (MMM).
A quick note on the purpose of this article: In many situations, I fully recommend this strategy be taken advantage of. There are many places to read about how much this approach can help one's portfolio. However, there are definite risks that are not addressed every time doubling one's dividend is endorsed. My goal is to ensure that the investor is aware that there are both advantages and disadvantages of employing this strategy in a portfolio, and how those disadvantages can affect returns.
Let us first lay out the assumptions:
- The stock is fundamentally sound and one the investor would like to own long term.
- Total return matters: Return comprises both capital appreciation and income produced by the stock (dividend and option income).
- The investor chooses call strike prices in the next month which balances the premium received and upside gains available.
As long as the stock's price at option expiration stays below the strike price of the call, the extra income will be earned with no second thought. However, this means that there is sideways or negative stock price movement. Because the investor's stock will be called away at the chosen strike price, the stock's upside is limited to the gain made by selling at the strike price. Therefore, the ideal scenario when doubling one's dividends is for the stock to close just below the strike price.
In fact, in an upward trending market, the net effect of this transaction can be a loss. Either the investor buys the stock again but at a higher price, or the investor does not re-buy the stock, but has missed out on its price appreciation.
We are able to calculate our higher and lower breakeven prices. The higher breakeven price is calculated by adding the premium received to the strike price. At any price above this, the investor would have earned more money by holding the stock and not having it called away. The lower breakeven price is calculated by subtracting the premium received from the current stock price. In the case of a declining stock, since the stock is collateral for the short call position, one does not have the flexibility to sell the stock if continued price decrease is forecast.
For an example, let's look at a covered call strategy in Coca-Cola (KO), a commonly owned dividend stock. Coke's current price is $79.16 and the investor will be selling calls from the next month (balancing the premium received to time decay earned). The two strike prices most likely to be used are those slightly above the current price, $80 and $82.50.
Upward Break Even Price
% Stock Increase To Lose
Lower Break Even Price
% Stock Decrease to Lose
We see that the price movements needed in order for this strategy to be a possible loser are not very large. In fact, Coke has risen 6.31% in the last seven trading days, meaning if one had sold a call a week ago then there are significant gains that will remain unrealized.
I would like to be clear that if the investor is already planning on holding this stock even through a decline, then the premium received from the call is helpful to soften the blow. However, let's say perhaps the investor does forecast stock price declines, and would therefore like to sell the stock now, and buy back in later at a lower price. By selling a covered call, he has removed that option of exiting his stock position.
To conclude, there are many times that selling covered calls on dividend stocks is a great strategy. As with all tools in the investor's arsenal, however, the investor needs to understand the risks that go along with the benefit, and double his dividends only when he deems the risk/reward favorable.