One way of doing just that can be found in the options market. Don't worry. The options market is erroneously viewed by many investors as far more risky than it is in reality. Sure, there are plenty of risky options strategies, but the one I want to explore jibes perfectly with theme of conservative investing with the intent of generating passive income.
I'm talking about covered calls, one of the most conservative options strategies an investor can employ. In layman's terms, a covered call is “covered” because you already own shares of the underlying stock. For example, if you want to write or sell covered calls on your 500 shares of Procter & Gamble (NYSE: PG), you would be able to sell five contracts. Each contract is equivalent to 100 shares of the underlying stock, so if you own 475 shares of P&G, you could only write four contracts worth of calls and so on.
There are multiple ways to use covered calls with dividend stocks to enhance your income stream, but before we get into the details, remember one of the primary risks with covered calls: Your shares can be called away from you if your stock trades above the strike price you sold the calls at.
Here's an example: You purchase 500 shares of XYZ Inc. at $50 in June and decide to sell five July $52 calls at $1 (that's just an approximation). That transaction results in $500 in income before broker commissions, not including any dividends you receive. Sounds pretty good, but if XYZ jumps to $55 before expiration day (the third Friday of every month), chances are your shares will be called away at $52 and you miss out on $3 in capital appreciation.
For that reason, investors that are firm in their intent to capture as much dividend income and capital appreciation from a stock as they possibly can might want to opt for writing covered calls with strike prices that are deeper out of the money. Of course that means less income because the options premiums will be lower, but an investor with a large stake can generate decent income over time with deep out-of-the-money covered calls.
Another strategy to explore is the dividend capture strategy, which is slightly more advanced. Here's how it works: Let's assume XYZ says in June it will pay a quarterly dividend of $1.50 a share on July 1. You do some homework and discover XYZ will go ex-dividend on June 26 (again, this an approximation). Some traders and investors would buy 100 shares of XYZ at $50 ($5,000) on June 25 and then sell a July $40 call to garner over $1,000 in additional income.
TheOptionsGuide.com sums up this strategy succinctly: As he had already qualified for the dividend payout, the options trader decides to exit the position by selling the long stock and buying back the call options. Selling the stock for $4850 results in a $150 loss on the long stock position while buying back the call for $870 resulted in a gain of $150 on the short option position.
At the end of the day, the investor nets a quick profit that comes entirely from the dividend but isn't forced to hold the stock for weeks or months just to get the payout.
A more passive investor may want to opt for the first strategy of selling deep out-of-the-money calls while an active investor can opt for the second plan. The bottom line is options can help boost an income investor's returns.
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