One strategy I favor right now is covered calls. This is essentially a way to generate an ongoing stream of income from stocks that don’t pay dividends or only offer a small yield.

— Elliott Gue, The Energy Strategist

Dividend-paying stocks are wonderful investments, as I discussed yesterday. If you don’t have any in your portfolio, I strongly recommend that you get some. 

But what if you already have a stock portfolio composed of stocks that don’t pay dividends or, if they do, don’t yield much?  Selling everything and starting over with high-yielders is one possibility, but in a non-retirement account the tax consequences of selling stocks could be counterproductive. Furthermore, you bought the stocks for a reason and you may not want to sell them before your investment thesis plays out. So, is there any way to enjoy the wealth-compounding benefits of dividends with your current dividend-deprived portfolio?

Description of Stock Options

Yes, there is a way, but it requires a bit of imagination. It involves the use of stock options. Options are an incredibly flexible tool that investors can use to reduce risk and generate extra income all at the same time. Options are derivatives — they derive their value from an underlying stock and represent the right (but not the obligation) to buy or sell 100 shares of the underlying stock by a predetermined date (expiration, which is the Saturday after the third Friday of the month). As such, options are not physical things like a barrel of oil or 20 tons of pork bellies, but rather are contracts between two parties that confer rights and obligations. This fact allows you to sell an option without owning it first.

There are two types of options, calls and puts. That’s it. And there are two sides to every option transaction — the party buying the option, and the party selling (also called writing) the option. The buyer of the option is said to have a long position, while the seller of the option (the writer) is said to have a short position.

A call option gives the buyer the right, but not the obligation, to purchase a stock at a certain price called the “strike” price. The buyer pays money to obtain this right.  Conversely, the seller of a call option has the obligation to sell his stock at the strike price if the buyer exercises his right.  In return for assuming this obligation, the seller receives money up front. The sold call option is considered “covered” because you only sell calls against stock that you already own.

Covered Call Writing Creates Dividends Out of Thin Air

Selling call options against your pre-existing stock positions (a.k.a. “covered” calls) generates income that is similar to receiving a dividend. For example, take Portfolio 2020  recommendation American Superconductor (NasdaqGS: AMSC), a wonderful “clean tech” stock that is capitalizing on wind energy, but one that does not pay a dividend. 

Let’s say that you buy the stock at its current price of $29 per share and wouldn’t mind selling it if it appreciated 20% (to $35) anytime in the next three months. The July $35 call option (i.e., the option that gives the buyer the right to purchase the stock at $35 any time between now and the expiration of the option on the third Saturday in July) is currently selling for $1 per share.  By selling this call option against the stock – remember, you don’t need to already own the call option to sell it — you receive a $1 “dividend” that equates to a yield of 3.4%  ($1/$29).

There is No Free Lunch

What is a call seller forfeiting? — the ability to participate in a stock’s gain above the strike price of the option.  Consequently, if the stock goes up in price, the stock owner’s profit is limited to $7 per share — the difference between his cost ($29 adjusted down by the $1 in call premium received, or $28) and the call option’s strike price of $35. Any share price appreciation above $35 goes to the call option buyer:

AMSC Covered Call: Profit/Loss at July Options Expiration (7-17-10)

Covered Call Writing Wins Most of the Time

As the table above demonstrates, covered call writing reduces your downside risk at all price points below your purchase price of $29. It also increases your profit at all price points between $29 and $36. The only scenario where the covered call is not superior is if the stock appreciates more than 24% ($36.01 or higher).

Profit off of Someone Else’s Low-Probability Gamble

What are the odds that a stock will appreciate by more than 24% in the next three months?  Unless you have insider information, I think it’s almost always a bad bet to make.  In fact, in American Superconductor’s case, the options market indicates less than a 17% chance that the stock will close above $36 at July expiration.  Consequently, 83% of the time writing the July $35 call will turn out to be the right decision. The beauty of options is that they let you profit from someone else’s risky (and often wrong) bets. If somebody is greedy enough to want to pay me money for the right to profit from something that has only a 17% chance of playing out, I’ll take his money every time. Even if the Greedy Gus strikes pay dirt, I’ll be happy with my 24% return in three months!

Quadruple That Yield!

And don’t forget that the 3.4% yield you receive for selling the July call option is only for three months. Assuming the stock stays around its current price at July expiration, you could write another three-month $35 call at that time (i.e., October expiration) and pocket another 3.4% dividend. Altogether, you could theoretically write this call four times per year and receive a total dividend yield of 13.6%. Pretty amazing for a stock that doesn’t pay a dividend!

Elliot Gue’s Real-Life Options Money-Maker

As the introductory quotation to this article makes evident, KCI’s own Elliott Gue, editor of The Energy Strategist investment service, likes the covered call options strategy.  To show you that this strategy actually works, let’s look at a real-life recommendation that Elliott made. In this article from Christmas Eve 2008, Elliott recommended buying integrated energy company Hess (NYSE: HES) for $48.82 and selling a May $55 call for $7.50.  At May 2009 expiration, Hess closed at $58.18.  Anyone who followed Elliott’s covered-call recommendation made a profit of $13.68 per share, or $7.50 plus ($55-$48.82). In contrast, someone who simply owned the stock made a profit of only $9.36 per share, or ($58.18-$48.82). Nice call Elliott!

Options are Not for Everyone

The risk of selling a covered call – besides losing out on upside appreciation – is that the call buyer will exercise his option and force you to sell the stock to him, which may cause you to incur a significant tax liability if your cost basis in the stock is low. Consequently, covered calls on stocks that you have owned for a long time (and which have significantly appreciated) work best in a tax-deferred IRA account. 

Maybe Worth a Try

If you are very bullish on a stock, simply buy the stock. If, however, you want to enhance your dividend income and reduce the risk of owning stock, selling covered calls against your stock holdings can help.

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Elliott has written a wonderful primer on low-risk options strategies entitled “The ABCs of Options to Hedge Risk.” This special options report and four others are yours free if you sign up for a two-year subscription to The Energy Strategist investment service.  No-risk guarantee: For the first three full months if you’re not completely satisfied simply call us for a 100% refund – no questions asked.