Bookmark and Share 22, Income Investor Who Focuses On Growth

"The income investor should seek stocks that pay a modest dividend while also running up in price."

Patrick Cain, Investor's Business Daily, Aug 17, 2010

Patrick makes a good point when he suggests buying stocks that have a good dividend yield and are trending up. In the article he lists 19 stocks that are trading near their highs, have solid Composite Ratings (a high IBD rating), and have a dividend yield of at least 4%.

In our opinion, that is a reasonable strategy in these low-interest times, especially for an income investor. However, we think an income investor can improve upon that strategy by selling out-of-the-money covered calls against those same stocks each month. Not only do you get 4%+ per year in dividends but you could get another 3%+ in call premium income. Or you could choose to write at-the-money calls for even higher call premiums.

For example, let's look at 6 of the 19 stocks that Patrick's screen turned up, along with their annualized dividend yields:

Company Symbol Annualized
Dividend
Yield
Bristol-Myers Squibb BMY 4.9%
Eli Lilly LLY 5.5%
Microchip Tech MCHP 4.7%
Pfizer PFE 4.5%
Philip Morris Intl PM 4.5%
Ventas VTR 4.3%

Not a bad list to choose from. But, let's take a look at what happens if you layer on a call writing program for extra income. We've added two columns below: the first assumes you write an option that is at least 5% out-of-the-money each month, and the second is the sum of the annualized dividend and call premium (the annualized call premiums in these examples are 12x the September cycle time premium for options that are between 5% and 9% out-of-the-money):

Company Symbol Annualized
Dividend
Yield
Annualized
5%+ OTM
Time Premium
Total
Annualized
Yield
Bristol-Myers Squibb BMY 4.9% 4.5% 9.4%
Eli Lilly LLY 5.5% 5.9% 11.4%
Microchip Tech MCHP 4.7% 4.2% 8.9%
Pfizer PFE 4.5% 9.8% 14.3%
Philip Morris Intl PM 4.5% 3.2% 7.7%
Ventas VTR 4.3% 2.9% 7.2%

Note that your mileage may vary as there are several variables that are difficult to model over a 12 month cycle, which include:

  1. volatility at the time the options are written
  2. earnings release cycles (none of the above have an earnings release before the September cycle)
  3. transaction costs
  4. moneyness, or the distance from the strike price to the current stock price at the moment you write the option (not all of these have $1 strike increments, so you can't always choose an option that is exactly 5% out-of-the-money, but all of the above are at least 5% OTM)

However, having said that, the main point is still valid: you can enhance the yield on just about any portfolio by writing near-term out-of-the-money covered calls against it. Even if you want to leave yourself some upside potential, you can probably squeeze another 3-4% income per year out of your portfolio with covered calls. And if an investor is willing to give up some of the upside potential he can do even better.

One negative of this strategy is that if your stocks rise by more than 5% in 1 month then you will either have to buy the options back (potentially at a loss) or let the stock get called away (in which case you've still made at least 5% on that position for that month but have forfeited any gains above the strike price (see Covered Calls For Dummies for more info). Also, note that when looking for trades that match your criteria, you will save a lot of time if you have an options screener.

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