Retirees seek reasonable, consistent yield without a threat to the nest egg. Last week I revisited a method for doing this, one I first described six years ago.
The Quest for Yield (Part 6): Enhancing the Yield from Your Dividend Stocks, written in March 2012 explained the concept. While I have made a few changes, it is working as expected. I hope to write a series of posts describing and explaining some of our current choices and trades. While this is not investment advice for any specific reader, those who need to increase their yield may find it interesting. (More on this subject below).
The program, simply described, consists of buying a good dividend stock and selling a call against the position. While there are many dividend programs and many covered call programs, there is a powerful synergy from putting them together. There is also skill in choosing suitable stocks and the right call to sell.
I began last week with IBM, emphasizing criteria for finding suitable stocks. This week I will focus more on the choice of which call to sell.
Choosing a Suitable Stock
The best stocks for this approach have the following characteristics:
- A reasonable dividend – 2.5% or more is fine.
- A good balance sheet.
- A reasonable payout ratio, providing confidence that the dividend can be maintained.
- Limited downside risk.
- A cheap stock on a P/E basis.
- Evidence of technical support.
We do not care about the immediate chances for an upside move. We do not care about the “organic” earnings growth versus share buybacks. We do not care if the stock is out of favor or boring.
We seek a safe platform for selling calls. Wherever someone sees a “value trap,” we see a candidate for this program.
Let’s start with the dividend history, an impressive record.
For valuation, I use FAST Graphs to verify that the current price is attractive.
Which Call to Sell?
The next step is to choose the right call to sell. There are scores of choices, but only a few fit the program. Here are the key characteristics.
- Reasonable absolute premium. Since we pay a commission on the trade, the sale price must be high enough to absorb that cost. We expect to make only one trade – selling the call – since it will either expire worthless or we will be “assigned” on it. It is important to know your commissions for each stage and keep them in mind. (I use Interactive Brokers, where the commission is about 0.7 of a cent per share and there are no fees for assignment). With all of this in mind, I look for a selling price of 23 cents or more.
- Short time period, for rapid time decay. Borntosell has many resources for those selling covered calls. This post and chart explain the pace of time decay.
- Good annualized yield. My goal is to generate 9% yield after commissions and fees, so each trade has a target higher than that.
- Capture the dividend.
We bought T at $29.40 on October 26th and sold DEC 30 calls for 86 cents. There is no dividend before the call expires; that would require a January call.
Other choices were the DEC 31 call for thirty-five cents, the NOV 30 for thirty-two cents or the NOV 31 for fifteen cents. The NOV 31 did not qualify on our minimum price criterion. The NOV 30 was a reasonable alternative, but the DEC 30 matches the time decay pace well and provides a bit more of a downside cushion.
Maintaining the position
If the stock remains below the strike, we pocket 86 cents for the call premium .and dividend. That is an annualized return of about 17.5%, even if the stock does nothing. If the stock moves to 30 or higher, we collect another forty cents and move on to the next trade.
If the stock declines, the calls expire worthless. We then sell another call with a new expiration date. We repeat this process until the stock moves higher than our sell target, where we have positioned the short call.
Putting It All Together
It is a good idea to have several positions in diverse sectors. I currently use 14 positions, with no more than two in a single sector.
Of our targeted yield of 9%, 4/5 of it comes from selling calls. Most people can take 5% yield and reinvest the rest. The yield payout comes from the dividends and call sales, not from selling your stocks. In that sense, it is like a regular dividend program. An advantage is that if the underlying stocks decline, the reinvested yield increases your position size. You are “buying low.” When stocks are sold (closing above the target price) you are “selling high.”
Can It Work for You?
Our choice from last week, IBM, made a heavily-criticized acquisition shortly after we did the trade. The stock moved lower and will provide a good ongoing example for this series. I will show that the income stream will continue, just as if you held the stock merely for the dividends. Every time a call expires, we’ll decide about the strike price for a new sale. Mostly because of the type of stock selected we do not view this as a trading program. In the fullness of time, we expect to break even or so on the stock while collecting dividends.
It was clear from last week’s comments that most people interested in an approach using options want to evaluate it as a trade, not as part of a portfolio. As we go along, I hope to provide some ideas about handling each type of position.
If you are an income investor, you might give this a try with a small, starter position. But beware. Here is what I wrote six years ago:
Here is the qualification test — hardly anyone can pass it!
You cannot look at your brokerage statement, the daily mark-to-market, the monthly mark-to-market, or anything else for ten years.
This is what you would do with a bond portfolio. You buy expecting to collect the coupon and the principal at maturity. It is a simple test, yet a difficult one. The bond investor does not worry about daily marks.
Psychologically, people cannot do this with stocks.
Disclosure: I am/we are long T. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Short calls against the stock