Market Beat: Dividend covered call strategy
Stocks that pay a decent dividend can be a good component for a portion of the equity allocation of an income-oriented portfolio. The income stream from the dividend yield can be taken as cash or re-invested into more shares of the stock as a form of dollar cost averaging.
One way to enhance the income is to combine dividend paying equities with an option strategy known as the covered call. A dividend covered call strategy is designed to produce income and provide for capital gains with relatively low volatility. Of course, options are not suitable for all investors and need to be thoroughly understood before using them.
Stocks can be selected based on a variety of parameters using different methodology. One factor to consider is the current dividend yield of the equity. You can also look at the company’s history of paying dividends and favor those stocks who have a long history of dividend increases. Price to cash flow and price to free cash flow are two more valuation metrics that can be analyzed. I tend to favor stocks that trade at good values, but do not rule out growth stocks.
Once the stock is selected you can sell covered calls on a variety of time frames. A quarterly basis can work well. One way is to allow for an upside price movement of 8 to 10 percent annually when selecting the strike price to sell.
Hypothetically, if a stock were to stay flat for a year, you could still collect 3-4 percent per year from the dividend and another 3-4 percent annually from call premium. In other words, the static return might be about 6-8 percent per year without any upside movement in the underlying stock and that can all be received as income.
Academic research has proven that covered call writing can enhance returns and lower volatility. The call writing and dividend income can partially offset losses to some extent.
Essentially you should attempt to identify companies with stable cash flows and strong revenues, that can continue to pay out some of their profits in the form of dividends. You might also want to screen companies for liquidity using those that trade in high volume and have highly liquid option contracts with tight bid-ask spreads, so you can enter and exit positions easily.
I prefer stocks that have the weekly options to provide more flexibility in trading around earnings reports and ex-dividend dates.
Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information is at his blog at http://www.sellacalloption.com or 775-657-8065. The mention of securities should not be considered an offer to sell or solicitation to buy investments mentioned. Consult your investment professional to understand the risks and/or how the purchase or sale of these investments may be implemented to meet your investment goals. Past performance is no guarantee of future results.