In today's volatile market, investors are looking for any edge they can get. With treasury yields at an all-time low and the S&P returning almost nothing over the last ten years, many are happy to put their money into blue chips with healthy dividend yields.
One strategy dividend stockholders can employ to beef up their returns is selling "covered calls" -- call options on stocks you already own. A call option is simply an agreement between buyer and seller that the buyer can purchase a particular stock from the seller at a specified price, the strike price, by the option's expiration date. If the stock is worth more than the strike price at the expiration date, the options holder will exercise the options, forcing the seller to part with them at the agreed-upon price.
Blue chips fit perfectly with covered calls for two reasons. First, their dividends act as a price floor, meaning if the stock falls investors are likely to jump in because of the improved dividend yield. Second, their low volatility means the share price is unlikely to soar past the strike price. Let's take a look at how this strategy might work in two different sectors.
AT&T (NYS: T) and Verizon (NYS: VZ) have a near duopoly in telecom with a majority of market share, and both are worth over $100 billion. These giants also pay the two highest dividend yields on the Dow, with AT&T's at 5.9% and Verizon paying 5.2%. Their stocks' 52-week range is relatively narrow, and both are also trading near their highs over the past year. These are stable businesses with stable stocks, and both have betas under 0.6 -- indicating low volatility in the shares.
April 2012 $40 calls on Verizon sell for $0.66, as of writing. Selling these would give you a 1.7% return and repeating the process three more times throughout the year, would net a return of 6.8% on top of the 5.2% dividend yield you're already receiving. Similarly, AT&T's April 2012 $31 calls sell for $0.50. Following the same process here would give you a relatively risk-free return of 6.62%, over the course of the year.
As you can see from the chart below, both of these stocks, especially Verizon, have been less volatile than the S&P 500.
AT&T Stock Chart by YCharts
Unless the S&P goes up more than 6% by April or any news drives these telecom titans dramatically upward, selling these calls should be a good bet.
Another sector where we can find high dividend yields and low volatility is pharmaceuticals. Merck (NYS: MRK) and Eli Lilly (NYS: LLY) pay some of the biggest dividend yields here at 4.4% and 4.9%, respectively, and both trade near their 52-week high. The two have betas under 0.7, as well.
Using the same strategy as above with the telecom companies, we could sell April $40 Merck calls for $0.72, giving us a 7.4% return for the year. April $42 calls on Eli Lilly trade at $0.68, which would yield a 6.7% return if the trade were carried out three more times over the year.
From the chart below, we see a similar pattern as with the telecoms when compared with the S&P.
Merck Stock Chart by YCharts
Eli Lilly and Merck both appear to be less volatile than the market, so I think the same 6% rule with the S&P should apply, provided no major news moves these share prices.
Foolish final thoughts
All of these scenarios assume selling out-of-the-money calls -- options that would expire worthless if the current stock price didn't change between now and expiration -- at a strike price of roughly 3% to 4% above its current trading price. The upside potential here is there is the steady revenue stream from the options premiums to add to your dividends, while the only downside is it limits your gain if the stock shoots up, since you'll be forced to sell. But if you were forced to sell, you would still profit from the sale of the stock, at least from today's prices, and you would keep the premiums you gained from selling the options.
Compare premiums at different strike prices and expiration dates, and you can probably find a combination that works best as a hedge on your dividend holdings. Selling options with a longer time horizon will bring you a greater lump sum now but ultimately less total money than selling options with a shorter time horizon and repeating those trades as the year goes by. Selling at a lower strike price will net you more on the premium, but carries a greater risk of your shares being called. For more on options, take a look at the Fool's options course here.
Selling covered calls is a great way to tack on more income to those quarterly payouts, and not only do dividend stocks provide a steady stream of cash flow, but they've also historically outperformed the S&P. For some picks from our experts on more dividend stocks that would fit right in with this strategy, check out this free report: "Secure Your Future With 11 Rock-Solid Dividend Stocks." AT&T is one of them. Find out what the others are by clicking right here.
At the time thisarticle was published Fool ContributorJeremy Bowmanholds no positions in the companies above. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.
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