This can be attributed to falling interest rates. Traditionally, income investments—whether through bonds or whatever—began to lose some of their luster with the passage of time. Lower interest rates mean lesser returns for investments, which again brings down the capability of many to earn a regular income.
Most investors live on income from interest-bearing bonds or Treasury yields or dividend stocks. Treasury bonds now return significantly less than in previous years. This decline has left everybody searching for alternative ways on how to increase the flow of cash into their respective portfolios.
Covered calls represent an innovative way to generate higher income. A covered call is, in essence, an options strategy whereby a shareholder selling call options on that stock is the same investor who owns shares in that stock. This means that the investor can acquire an additional source of income in the form of the premium received by the buyer of the option. As long as the covered call is applied correctly, it should be possible to increase dividend-paying stock and ETF returns.
One of the dividend-focused ETFs to use for this strategy is TLT, the ETF tracking the Barclays US 20-Year Treasury Bond Index. This is one of the most popular ETFs among investors, who love its monthly dividend payment. Using covered calls with TLT shares can really amplify income threefold or fourfold compared to using dividends alone.
But a covered call strategy applied to dividend-paying assets can mean major income amplification. Here’s how to do that using TLT as an example, as well as the income enhancement potential it offers.
Step-by-Step Guide to the Covered Call Strategy
Understand the Basics of Covered Calls
A covered call is when you sell a call option on a stock or ETF you already own. On a call sale, the premium is received upfront. On such a sale, the option buyer has the right (and not the obligation) to buy the shares at an agreed strike price prior to the expiration of the option. If the price goes up above this agreed-on strike price, you allow the buyer to purchase stock from you at this relatively lower price while retaining the premium.
Use a Dividend-Paying Security in Your Covered Call Strategy
One great strategy for using a dividend-paying security such as TLT is a covered call strategy, as this will add both dividend income and the premium earned from selling call options. At least, TLT has one good reason to attract a potential investor: its monthly dividends. These currently pay an approximate annualized rate of 3.7%. Combined with the income from covered calls, it adds up to a lot.
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Structure of Covered Call Trade
We now explain how we’ll structure this through the next example:
- Buy stocks: Assume that we own, for instance, 1,000 TLTs of stocks sold at a market price of $90.70 per stock. Therefore, we will invest a sum of $90,700.
- Sell call options: You sell 10 call options with a strike price of $91, which are to expire in one year. Every call option contract covers 100 shares and is sold at a premium of $7.70 per share. This brings an initial cash inflow of $7,700, thereby enhancing your income right at the start.
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Earn Dividend Income
You will continue to earn TLT’s monthly dividends while holding the stock. For 1,000 shares, TLT pays about $3,618 in dividends over a 12-month period. That’s dividend income adding up alongside the call option premium collected.
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Evaluating the Trade Outcome
At the end of the year, when the call options expire, there are two possible outcomes:
- If TLT’s price is still below $91, the call options expire worthless, and you’ll hold the premium, the shares, and all of the dividends received in a given year.
- If TLT’s Price Goes Beyond $91: The holder of the call options may now exercise his right to buy your shares at the strike price of $91. You sell the shares at $91 and get out with a minimum capital gain added on top of the dividends collected and the option premium obtained.
Calculation: How Much Can You Make?
Let’s break the total income earned in the TLT example to illustrate how a covered call structure can triple your dividend income.
- Dividend Income: $3,618 over one year.
- Option Premium Selling call options: $7,700
- Capital Gains: If the shares were sold at $91, the capital gain would be minimal but positive.
Total Income from this structure is therefore:
- $3,618 (dividends) + $7,700 (option premium) = $11,318
This yields a gross return exceeding 12% on your investment, substantially above the 3.7% annualized from dividends.
Key Benefits to Using Covered Calls
- Extra Income: Selling covered calls gives you income in the premium that represents an increase to the dividends you would get on the stock alone.
- Lower Risk: It is less risky compared with outright buying or selling as you already have the shares. You have the underlying, which cushions against the likely loss.
- Limited Loss Exposure: The maximum loss experienced is the decline in stock value, while the premium also acts as a cushion from loss.
Important Considerations and Risks
While covered calls are a great way to add income to a portfolio, there are a couple of things to keep in mind:
- Opportunity Cost: If the price of the stock jumps up very significantly above the strike price, your profit is limited at the strike price and you lose all opportunity beyond this level.
- Market Conditions: It is excellent for covered call strategies in neutral or marginally positive markets. Highly volatile situations increase the chances of swift movement of the stock in the wrong direction against a covered call.
- Expiration Date: Select a good expiration date. With higher premiums possible, an extended expiration commits you to a longer series of the trade.
Pitfalls to Avoid With Covered Call Strategies
- Select Appropriate Strike Prices: Select a strike price which is slightly above the current market price. In this manner, there is a possibility of capital appreciation along with an appropriate premium.
- Monitor Dividend Payments: In dividend-paying stocks, monitor the ex-dividend date. Selling options near that date can lead to premature assignment of options which may decrease your profits.
- Reinvesting Option Premiums and Dividend Income: The concept of reinvesting option premiums and dividend income is to build compounding of returns over time, thus fortifying long-term portfolio performance.
Conclusion
You can triple your dividend income and much more with the covered call. In a low-interest environment, it can create large increases in income. Covered calls are restricted and require planning ahead; they are a very low-risk, high-yield way to maximize your dividend income from dividend-payer stocks and ETFs.
If you want to learn more about options strategies, you probably should find out about some of the other techniques professional traders use. Some income-generating strategies are used regardless of market direction and include cash-secured puts and iron condors. With a well-rounded knowledge of options, you can take your investment income to new heights while navigating today’s shifting market conditions.