Retirees seek reasonable, consistent yield without a threat to the nest egg. I want to revisit a method for doing this, one I first described six years ago.
The Quest for Yield (Part 6): Enhancing the Yield from Your Dividend Stocks, written in March 2012 explained the concept. While I have made a few changes, it is working as expected. I hope to write a series of posts describing and explaining some of our current choices and trades. While this is not investment advice for any specific reader, those who need to increase their yield may find it interesting. (More on this subject below).
The program, simply described, consists of buying a good dividend stock and selling a call against the position. While there are many dividend programs and many covered call programs, there is a powerful synergy from putting them together. There is also skill in choosing suitable stocks and the right call to sell.
In this first post of my planned series I will list and briefly describe the steps involved using an actual recent trade in (NYSE:IBM). Each week I will go into more detail on a different step. The topic is too large for a single post.
Choosing a Suitable Stock
The best stocks for this approach have the following characteristics:
- A reasonable dividend – 2.5% or more is fine.
- A good balance sheet.
- A reasonable payout ratio, providing confidence that the dividend can be maintained.
Limited downside risk.
- A cheap stock on a P/E basis.
- Evidence of technical support.
We do not care about the immediate chances for an upside move. We do not care about the “organic” earnings growth versus share buybacks. We do not care if the stock is out of favor or boring.
We seek a safe platform for selling calls. Wherever someone sees a “value trap,” we see a candidate for this program.
Let’s start with the dividend history, an impressive record.
For valuation, I use FAST Graphs to verify that the current price is attractive.
IBM has already cracked various support levels, which explains why it is unloved and cheap. Technical analysts reach differing conclusions based upon the time frame, but there is evidence of long-term support here.
Which Call to Sell?
The next step is to choose the right call to sell. There are scores of choices, but only a few fit the program. Here are the key characteristics (which we’ll discuss more in future posts).
- Reasonable absolute premium.
- Short time period, for rapid time decay.
- Good annualized yield.
- Capture the dividend.
In my last WTWA edition I included commentary on IBM and noted that we would probably do this trade. It is not off to a great start, but that is fine. This program is not about capturing short-term stock moves. Buy 100 shares of IBM stock (we paid about $129) and sell a DEC 135 call (we collected $1.66). The overall cost of the buy/write was about $127.34. Do as many spreads as needed to fit your overall size. To get the best pricing, you should enter the order as a spread. We choose a call at a price where we are willing to sell the stock.
We will also collect a dividend of $1.57 in early November.
Maintaining the position
If the stock remains below the strike, we pocket $3.23 for the call premium and dividend. That is an annualized return of about 15%, even if the stock does nothing. If the stock moves to 135 or higher, we collect another $6 and move on to the next trade.
If the stock declines, the calls expire worthless. We then sell another call with a new expiration date. We repeat this process until the stock moves higher than our sell target, where we have positioned the short call.
Putting It All Together
It is a good idea to have several positions in diverse sectors. I currently use 14 positions, with no more than two in a single sector.
Most of the yield (80%) comes from selling calls. Most people can take 5% yield and reinvest the rest. The yield payout comes from the dividends and call sales, not from selling your stocks. In that sense, it is like a regular dividend program. An advantage is that if the underlying stocks decline, the reinvested yield increases your position size. You are “buying low.” When stocks are sold (closing above the target price) you are “selling high.”
Can It Work for You?
If you are an income investor, you might give this a try with a small, starter position. But beware. Here is what I wrote six years ago:
Here is the qualification test — hardly anyone can pass it!
You cannot look at your brokerage statement, the daily mark-to-market, the monthly mark-to-market, or anything else for ten years.
This is what you would do with a bond portfolio. You buy expecting to collect the coupon and the principal at maturity. It is a simple test, yet a difficult one. The bond investor does not worry about daily marks.
Psychologically, people cannot do this with stocks.