The formula for how much you make in dividend income is rather straightforward:
Dividend Income = P x Y
P: Portfolio Value
Y: Dividend Yield of Portfolio
I can see four obvious ways to increase dividend income. Let’s call these the Four Dividend Growth Brothers:
The Fifth Brother: Covered Calls
We all know the four Baldwin Brothers: Alec, Daniel, Billy and Stephen. But, just like the seldom-mentioned-but-highly-successful fifth Baldwin brother, Boris Baldwin, covered calls seem to get no credit for the tremendous potential they have to juice dividend growth investing returns.
What is a Call?
The following two paragraphs get a little technical, but I promise that if read through it, then consult the Investopedia page to further your knowledge, you could quickly be on your way to juicing your dividend income growth by 1-2% per year. So, please bear with me…
A call is an option, which is just another term for a contract between you and another person. If I buy a call, I pay a price (the premium) for the right to buy 100 shares of a stock (the underlying) at a given price (the strike price) at or before a given time (the expiration date). For instance, AT&T (Ticker: T) closed at $33.13/share on Thursday. I can buy a call for $59 (the premium) that will give me the right to buy (exercise the call) 100 shares of AT&T (the underlying) for $35/share (the strike price) on or before October 16th, 2015 (the expiration date). Now, why would I ever pay to buy stock for higher than the current price? Well, what if AT&T is trading for $40/share on or before October 16th? I get to buy those 100 shares for $35/share and could sell them right back at market prices ($40), making a quick $500; backing out the cost of my $59 call, I netted a profit of $441. If AT&T never goes above $35, well, I just wasted $59, but thanks for playing.
Once again, there are only four components to any call:
- The Underlying: The stock that could be traded if the option is in the money (strike price below market price)
- The Premium: The amount paid by the call buyer to the call writer to enter into the arrangement
- The Strike: The price at which the shares will trade hands if the option expires in the money
- The Expiration: The latest point in time when the call option can be exercised.
That’s from the buyer’s perspective, from the seller’s perspective, I’m on the trade from the opposite side (writing a call). I collect that $59 today and pray to God that AT&T stays under $35/share thru October. If it does stay under $35/share (referred to as out of the money, because no shares are exchanged), I keep the $59 premium and walk away. If AT&T is trading for over $35/share (or, in the money), I have to buy 100 shares on the open market (at whatever price they’re at), and then sell them to the call buyer for $35.
You can clearly see the risk in writing calls. Your losses are unlimited. If AT&T rises to $70/share (which would be an insane valuation, but anyway…), then as the call writer I would have to go out and buy 100 shares of AT&T at the market for $7,000, and sell them to the call buyer for $3,500—a huge loss of $3,441 (I still keep the $59 he paid me at the outset). This is called writing a naked call.
What is a Covered Call?
In a covered call, unlike with a naked call, I already own the shares at the outset. In the above example, rather than having to buy those 100 shares of AT&T for $7,000, I would simply deliver the call buyer the shares I already owned in exchange for $3,500. You’d be pretty upset when AT&T rose to $70, since your shares were already earmarked for sale at $35, but you wouldn’t have to come out of pocket for anything. A covered call is also sometimes referred to as a buy-write, because you buy the stock while you simultaneously write a call against it.
To put a covered call strategy very simply:
This strategy is a perfect fit for dividend growth investing (DGI), because for a lot of the tried-and-true dividend growth companies (Think JNJ, PG, or XOM) you’re not holding them for big share price appreciations, anyway. You’re holding these companies primarily for the dividends they pay, an expectation to increase those dividends in the future, and for a little bit of share price appreciation.
Benefits of Covered Calls in DGI:
- The premium collected when you write a call against one of your positions can immediately be used to buy more shares of any stock (to collect more dividends).
- You continue to collect the dividends on the underlying security you wrote the call against.
- If one of your companies goes ex-dividend during the call period (the period of time between writing the call and the expiration), the stock price will drop by the amount of the dividend—diminishing the chances that shares will rise above the strike price and get called away.
Risks of Covered Calls in DGI:
- If the call goes in the money and shares are called away, you will, of course, lose the dividend income associated with those shares. Granted, you will get paid by the call owner for those shares, but you will be paid a price that will make you unable to buy back the full position. In our extreme example with AT&T, the call buyer will pay you $3,559 ($3,500 for the shares and $59 for the call premium) for your 100 shares. If you wanted to buy back into AT&T, you’d only be able to buy 50.84 shares.
- Note: This risk is mitigated, though, by one’s ability to buy back into any company. At $70, AT&T would be trading for an extremely low yield. You could instead choose to invest in a more fairly valued company (VZ, FTR, TWC), and capture back most/all of the yield you lost while maintaining your sector allocation.
When Covered Calls Go Wrong
For most forms of long-term investing, covered call strategies don’t really work. If you’re investing for long-term price appreciation, there’s often no point in giving up your upside for some small payment today. You never know when a stock of yours will become in favor and skyrocket in price. Case in point…
In mid-2012, I owned 100 shares of NXPI—which was a small-cap near-field communication device maker. This was on the cusp of the touchless payments movement that is now commonplace in most devices, credit cards, and Point-of-Sale systems. The stock hovered in the 20’s for over a year. I was impatient (and stupid) and I wrote a covered call at $30 that expired in spring of 2013. NXPI expired at $30.25/share, so I was forced to sell for $30. Not that big of a deal, except that NXPI went pretty much straight up from there…
The lesson is clear, if you’re investing for the purposes of share-price appreciation, then writing a covered call is counterintuitive to your investing strategy and should probably be avoided. Similarly, even for positions in a dividend growth portfolio that you see as considerably undervalued or volatile, then covered calls should also be avoided. For instance, I would not write covered calls for stocks like Atwood Oceanics, Starbucks, Visa, Hi-Crush, Disney, or National Oilwell Varco because they’re either growing gangbusters (SBUX, V, DIS) or I believe are significantly undervalued (ATW, HCLP, NOV). In these stocks, I’m expecting significant share price growth, so I don’t want to cap myself with a covered call.
However, for many other positions I think the hi-growth phase is over and valuations are fair. For companies like Unilever, Proctor & Gamble, BHP Billiton, Canadian National Railway, and AT&T, covered calls are probably a good strategy.
Checklist for Covered Call Candidates
I like to see the following attributes in a stock before I write a call against it:
- Not Undervalued: Within 20% of its consensus 12-month price target (you can find this on Yahoo! Finance’s Analyst Estimates page for any stock)
- Low-Growth: 3-Year Revenue Growth Estimates <10% (likewise, Yahoo! Finance)
- Adequate Premium: This gets a little complicated, but you need to be fairly compensated for giving up your upside. A reasonable rule of thumb is to look at premiums six-months out and at strikes 5-10% above the current stock price. For that option, I like to see premiums that are at least 2-4% of the stock’s value.
- You own at least 100 shares of the stock. You can’t write a covered call against a position smaller than 100 shares.
The proof is in the pudding (for me, at least). In early February I wrote calls against a few of my low-growth, fairly-valued positions (see portfolio here) and collected about $1,600 in premiums. These calls are all doing very well so far. Meaning, the stocks have meandered since then. I’ve still collected the dividends that those stocks paid out, and the $1,600 I collected has already been reinvested in other shares (paying even more dividends). These options expire 4-6 months from now, so it’s still possible I have to sell shares at a discount later on, but that’s a reasonable risk for me given the reward.
I’d love some questions. Please comment below!