Any income-hungry investor knows how challenging today's market environment is. With a 10-year yield of 1.5% and a 30-year yield of 2.6%, longer-term U.S. Treasuries really no longer have a place as a long-term investment in a "normal" portfolio. The fact that banks, as well as the Federal Reserve has been gobbling up large amounts of Treasuries should not lead the typical investor - who is neither able to borrow at interest rates lower than treasury yields, nor is conducting monetary policy - astray.
With this classic low-risk asset all but removed from the equation for the common investor, alternatives near the lower end on the risk spectrum include government bonds from countries that do not enjoy safe haven status, and investment-grade corporate bonds.
It is also possible to take advantage of what is still a novelty for most investors - yields being higher for stocks than they are for bonds. While stocks of companies that are relatively safe and pay decent dividends have been rising recently, there are still opportunities to be found, especially when they only need to clear the low hurdle of being a better investment than Treasuries.
When combined with another popular income strategy - selling covered calls - the income generated can be substantial, and, assuming this is done with a portfolio of low-risk stocks, the probability of a negative outcome over a long (say, 5-10 year) horizon is quite small.
Example: Chevron Corporation (CVX)
To show how this could be done in practice, I will use Chevron as an example. This large-cap, integrated energy company is relatively low-risk. Its dividend has risen by 5-12% per year in each of the last four years and currently yields 3.35%.
The option contract used for this example is the Jan 19, 2013 contract with a strike price of $115 - 7% higher than the current market price of $107.43. The bid price for this contract is $2.08 per share. Let's say we buy 100 shares and simultaneously sell one option contract.
| Cash (out)/in | |
| Long stock - 100 shares | $(10,743) |
| Short a Jan. 2013 $115 call | $208 |
| Net outlay | $(10,535) |
| Dividends -- 90 cents per quarter | $180 |
| Maximum profit potential | $1,145.00 |
| Return if unchanged | $388 |
| Breakeven | $103.55 |
If Chevron is trading at 115 or higher when the option expires, the maximum profit, $1,145, will be realized. That amounts to a 10.9% return on the initial cash outlay, or 21.4% on an annualized basis.
To isolate the return derived from the dividends and option premium, we calculate the "static return", which assumes no change in the stock price during the period. That would give us $388 ($208 from the call premium and $180 in dividends), which is a 3.7% return, or 7.3% annualized.
The breakeven price for this trade is $103.55, which is 3.6% below the current market price for Chevron shares.
That's how you roll
So what happens on January 19, 2013? If the stock price is above 115, you close the option position before expiration and sell a new one with a later expiration date and a higher strike price. If the stock is under 115, you let the option expire worthless before selling a new one.
At the outset, I would recommend setting some criteria for future call sales. For instance, the highest and lowest strike prices that would be used. In this case that could be in the range of 90-140, meaning that you would never sell a call option with a lower strike than 90 (since you would not want to lock in any losses if the stock fell that far) and if the stock rose above 140, you would let your shares be called away and use the proceeds to buy a more modestly priced/ higher-yielding stock.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
