Retirees seek reasonable, consistent yield without a threat to the nest egg. I am continuing my series on my favorite method for achieving this objective.
While this is not investment advice for any specific reader, I hope that some will find it both interesting and useful.
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. Beyond the initial trade, there are many questions about how to handle the movement in the underlying stocks. I thank everyone who has joined in the comments. There are many good ideas for new themes and examples for future posts.
While I cannot explain everything in a single post, the entire series will provide a comprehensive look. Every trade is something we actually made for client accounts. Here is a review of the past articles, the stock cited, the issue illustrated, and a comment on where we stand.
|1||IBM||Stock selection||Stock has declined and then rebounded. Will the calls expire worthless? If so, which new ones will we sell? Too soon to say.|
|2||T||Which call to sell||We sold the DEC 30 call which is now slightly ITM. With many good alternatives, we may let the stock be called away.|
|3||GIS||Position management||We are short the JAN 47.5 call, which is significantly out of the money after the recent market decline. We’ll collect the dividend in early January and reassess.|
|4||SJM||Losing a stock via assignment||The choice of call, based on our willingness to sell, worked well. The stock has declined again, making it a promising candidate for a new round.|
Royal Dutch Shell: Diversity and Timing
I have been emphasizing the importance of viewing the program as a portfolio instead of worrying about how you are doing on each trade. To do this successfully you should avoid being overloaded in a single sector. In general, I have no more than two positions (out of fourteen) in the same market sector. Sector timing can also be helpful. Since I view oil prices as near a technical and fundamental support level, this is a good time to add an oil stock.
Let’s see how Royal Dutch Shell (RDS.A) fits the bill.
Review: Choosing a Suitable Stock
I discuss this more fully in the IBM article (check table above). 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 for RDS-A. The current level is fine, but the pattern clearly reflects some of the change in oil prices.
For valuation, I use FAST Graphs to verify that the price is attractive. It looks quite good now and will be even better if oil (NYSEARCA:USO) price upside provides an additional earnings boost.
This investment included two elements, both executed on 11/19:
- We purchased stock at $61.50.
- We sold the JAN 65 C for eighty-two cents.
- There is no scheduled dividend before the call expires.
Here is the chart.
Despite the market pressure, we are down only slightly on the stock prices. Our time period is two months, a bit longer than we typically choose. Why? The January choices all looked better than those in December. If the call expires worthless, it will represent an annualized gain of about 8%. In exchange for a slightly lower than usual return on the call sale, we have a potential upside of $3.50 on the stock. If the stock is called away at that price, we’ll have an annualized return on the stock portion of over 40%. This tradeoff reflects our attitude about the stock and sector potential.
- Choosing a stock includes both the standard criteria and how well it fits the portfolio.
- Portfolio management includes both diversification and choosing sectors that are trading at support levels.
- The call sold can tilt either toward maximizing the premium or allowing more room for appreciation.
Putting It All Together
One advantage of this program in times of market stress is that the checks keep coming. Of our targeted portfolio yield of 9%, 4/5 of it comes from selling calls. Most people can take 5% yield on the original investment and reinvest the rest. The yield payout comes from the dividends and call sales, not from selling our 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?
The RDS.A idea is still a good one, as are some of the past choices. Experience is good, but you should start small while you get the hang of this method.