I've been building a fixed income portfolio, as mentioned in my previous article, designed to generate a safe and consistent monthly yield. While many of these funds are great fixed income investments, I also like the idea of purchasing equities for the capital appreciation. But unfortunately, many promising dividend stocks simply don't pay a high enough dividend.
To solve these problems, I've started to write covered calls against dividend paying stocks that are delivering nice capital gains. The risk with the strategy is that the stock will appreciate too much and send the call options into the money. If those options are exercised, you still realize the capital gains but the dividend could be missed and or the capital gains are negated.
Kraft Foods is a Great Example
Here are the mechanics of this kind of trade:
Kraft Foods (KFT) has appreciated 9% so far this year, making it a great stock to own for growth investment, but only pays a 2.84% dividend yield for income investors. But the January 2013 $45.00 call options are trading at around $0.25. Combined with the $0.29 dividend yield, the "effective yield" jumps to around 3.5% writing just one call option like this per year.
Phillip Morris International (PM) has appreciated 16% so far this year, making it also a great stock for growth but it pays a 3.37% dividend yield. The January 2013 $100.00 call options are trading at around $0.67. Combined with the $0.77 dividend yield, the "effective yield" jumps to around 4.1% writing just one call options like this per year.
Looking at the Trade Dynamics
There are a few dynamics to this trade to consider:
Writing more aggressive call options can increase the "effective yield" even more. Obviously, this can be done in a couple of different ways. First, call options can be written more often than once per year, which means more premiums can be collected over the same time period. Second, writing call options that are closer being in-the-money pay higher premiums.
Once the trade is placed, the primary concern is with the call option going in the money and being exercised. The problem is that this would negate the dividend payment by forcing a sale of the stock and leave only a capital gain - not ideal for an income investor. Or, it would force the investor to buy back the option at a loss roughly equal to the capital gain - not ideal either.
Considerations for the Trade
The best solution is to these problems is to focus on writing call options that are enough out of the money to avoid them being exercised. If they are exercised, simply sell the option at a loss that is recouped by writing a call option further out (rolling it out). Keeping these factors in mind and watching for key news can help avoid most bad situations.
In the end, pairing simple covered call options with blue chip dividend stocks can be used to create a nice income portfolio for more active investors.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in KFT over the next 72 hours.