- Personal Finance
Turn a dividend stock into a money machine.
How to sell covered calls on dividend stocks.
My investment income strategy concentrates on three techniques to create investment income.
Interest from bonds and dividends are two, but this hub is dedicated to the third technique which is income from selling covered calls on dividend stocks. Dividend stocks are a key component of every income investor's portfolio. When you add income from covered calls you have "icing on the cake."
Using covered calls to boost income on income producing stocks is my focus today.
Do not confuse the income strategy of selling (also known as writing) covered calls on income stocks with the strategy of trading options.
I respect options traders very much but if you listen carefully to these traders they will admit that they do not consider options trading investing.
Selling covered calls on dividend stocks is an investment strategy. Your goal is to own a quality company that pays dividends then sell call options to boost your income.
You do not need a professional to implement this strategy. Do not try to find an options trader to help you. You may be lucky enough to have an adviser that believes in this strategy and that has the time to implement it for you. If not, I encourage you to learn how to do it yourself. In this Hub, I will help you learn about this strategy.
Here is how I select a dividend stock on which I can make additional money by selling covered calls.
I pick stocks that pay a dividend regularly and that means they pay 4 times a year, every year. The company has to create more earnings than the dividend paid as measured by earnings per share (EPS); and the company has to be solid as measured by D/E (debt to equity) ratio.
You want to pick a company that you can stomach owning if the stock market dives. This is the reason you want to buy a company with a nice dividend yield and a company that you are pretty sure will not go out of business any time soon.
Five Criteria for selecting a stock on which to sell a covered call for more income.
- Pays a regular dividend and has for years
- Earns more than the dividend
- Had as solid d/e ratio
- Has a beta of 1 or greater
- Has a call option available with volume
Many boring companies meet four of these criteria including earnings, dividend, and debt to equity ratio. However, unless the company has some price volatility, an option buyer may not be willing to pay you money just for the privilege of buying your stock at the strike price.
This is why I include looking for a beta of 1 or greater. Beta is a measure of price volatility of the stock. Remember you are selling -emphasis on selling- an option. The buyer has to think they are getting a deal by paying you for the option to buy your stock at a price lower than they expect it to be in the future.
Where to start?
If you already own some dividend producing stocks begin with these. Type in the symbol of the company you now own or you want to buy and look for the call option list. Some companies may not even have options available. Look at every dividend producing stock you own if none has options then look for a company that pays a nice dividend that you might want to own.
When you have a company in mind, look for an option that is 60 to 90 days out. The data you need to know are the strike price, the expiration date and the premium the call buyer will pay you for the privilege of buying your stock at the strike price. Note both the price information like current bid, current ask, the high and low of the day as well as the volume traded of the option because with options you may find an attractive bid and ask but no volume which means no one will buy it from you.
Now do the math.
I use this handy little covered call calculator to help me determine if selling a call is worth it to me. I enter the strike price and my cost basis. Strike price minus the cost basis is the gain you will make if the call buyer actually takes your stock at the strike price. That gain divided by the cost basis is your gain yield. Your income from the call premium divided by the cost basis is your premium yield.
I have provided an example using Darden Restaurants, symbol DRI. I own this stock and sell a lot of calls on it.
CALL OPTION CALCULATOR
Darden Restaurants DRI October $55 Call
Are you willing to hold onto a stock until the option expires?
A downside risk is always present when you are dealing with stocks. The downside risk of this strategy is that Darden stock could go down to below the strike price. The call buyer does not have the obligation to buy your stock and they will not if it is under $57.50 at the expiration date in October. Moreover, the stock price could even go below what you paid for it $52.00
However, a good dividend producer like Darden will most likely continue to pay you that very nice 4.25% dividend and in the future you may be able to sell another call to boost your income.
This strategy is for income boosting not for capital gains. Yet, if the person who paid you for the option to buy your stock at $57.50 actually exercises that option, you not only get to keep the income from the call you will also receive a gain of over seven percent.
An income investor can live with these two options.
I have many practical examples of these types of trades on my website. I hope you will learn how to employ this strategy and allow your investments to create your income instead of your hard labor.
Very Truly Yours,