How You Can Combine the Power of Dividends with the Power of Covered Calls

Did you ever wonder how you can generate yield and, at the same time, reduce your risk? This might sound too good to be true but this is achievable with discipline and knowledge. For starters, many judicious investors purchase dividend paying stocks or exchange traded funds (ETF). The company pays out a dividend, usually on a quarterly or monthly basis. This dividend is the extra income earned and can also be used as a buffer in case the share price declines. In many cases, dividend-paying stocks tend to be mature, well-established companies. For this reason, investors have the luxury of enjoying the combination of consistent dividend payments with an opportunity of price appreciation (through the price increase of the stock).

TIP: To be eligible to receive the dividends, you need to purchase the stock or ETF before the ex-dividend date. If you purchase the stock on or after the ex-dividend date, you will not receive the upcoming dividend. To find out when the ex-dividend dates are, refer to financial websites (or your online broker's trading platform). You can also visit TMXmoney.comNOTE - This link will open in a new tab. or download the TMX Money Dividends app from the App Store.

Now, let's take this concept to another level. Can you obtain higher returns than just collecting the dividends and price appreciation? Yes, this is possible. An investor would need to combine the stock position with a written call option on it. This strategy is called a covered call. An investor who owns the stock (or ETF) writes call options representing the equivalent amount or less, and can earn premium income without taking on additional risk. The premium received adds to the investor's bottom line regardless of outcome. This strategy even offers a small downside "cushion" in the event the stock declines and can boost upside returns. That being said, this benefit comes at a cost. As long as the short call position is open, the investor will be capped at the strike price^footnote* of the call option. If the stock price rallies above the call option's strike price, the stock is increasingly likely to be called away. Since the possibility of assignment is central to this strategy, it makes more sense for investors who view assignment as a positive outcome.

TIP: For the written call option position to be considered covered, the investor must hold 100 shares of the underlying stock per call option written.

For example, at the time of this article, ZEB (BMO Equal Weight Banks Index ETF) paid a monthly distribution of $0.074 per share for a dividend yield of 3.06%. This dividend yield is calculated using the total dividend distributions in a year divided by the stock price. Let's compare two hypothetical investors: Mike buys ZEB for $26. Julie buys the same ETF for $26 and writes a 90-day $27 call on ZEB for $0.30 per share. The $0.30 per share is the call premium that Julie receives when she writes the call option. This call premium is equivalent to an extra $0.10 per share ($0.30 ÷ 3 months) on top of the $0.074 per share ZEB pays on a monthly basis. Ultimately, both Mike and Julie will receive the dividends if they are shareholders on the record date. Let's reflect on what Julie is doing here. The call option on ZEB that she writes gives her an edge because of the option premium that she collects. But if Julie gets assigned on her call option, she has to deliver her ETF units for $27 (the strike price of the call that she wrote). When Julie writes the call option, she is ready to sell her ZEB units for $27 (the call option's strike price).

Let's take a look at a few scenarios:

1. If ZEB remains stable during the course of the 90 days (or three months), the main source of return will be coming from the dividend distributions of $0.222 per share (3 x $0.074). However, Julie earned an additional $0.30 from the covered call premium. Her return increases to $0.522 (135% higher than Mike's income from the distributions).
2. If ZEB rallies up to $27.30 from $26 (up 5%) during the 90 day period, Mike could take his profit and earn a 5% return plus the dividends received. Julie's call options will be assigned because the stock price ($27.30) exceeded the strike price ($27). She can still profit from a 3.85% gain from $26 (entry price) to $27 (strike price). However, Julie could not profit all the way up to $27.30 because of the $27 call options she wrote. Nonetheless, Julie will also receive the dividend payments (if she is the shareholder on the record date) plus the call option premium of $0.30 that she received from the covered call strategy. Therefore, Julie's total profit is $1.522 ($1.00 + $0.222 + $0.30). This results in the same profit per share as Mike's ($1.30 + $0.222).
3. If ZEB drops by 5% to $24.70, Mike will incur an unrealized loss of $1.30 ($26 - $24.70) but Julie's loss will be 23% less than Mike's loss (excluding the dividend received). Her loss is reduced because of the $0.30 per share premium she received from the covered call strategy. Therefore, Julie's loss will only be $1.00 vs. Mike's $1.30 per share loss. Since Mike's acquisition price is $26 and Julie's is $25.70 ($26 - $0.30), Julie's risk is lower than Mike's. This is one of the many reasons why knowledgeable investors use covered calls.

To summarize, properly selecting dividend paying stocks or ETFs is a sound approach. Many investors, including investment advisors, support this strategy as it provides a steady stream of income from dividends. Not only does this strategy generate income for the investor, they could also benefit from an increase in the stock price. To further enhance the stream of income from the dividends, investors should consider a covered call strategy to amplify the yield from holding a stock position. Until the next article, here's some food for thought: If you have a stock that does not pay dividends, you can write covered calls on a quarterly basis to simulate a stream of dividend payments.

Until next time, to learn more about covered calls, please visit www.m-x.ca.