With the recent rash of dividend cuts by historically dependable dividend-paying companies, income investors are finding it increasingly challenging to find safe high dividend yields. Indeed, Standard & Poor’s expects 2009 to have the biggest drop in dividend payouts since 1942. The market decline has created many accidentally high dividend paying stocks, as companies who’ve maintained their dividend payouts in spite of share price declines suddenly find themselves paying out record high dividend yields. The other edge to this sword is that many companies are slashing their dividend payouts to conserve cash, reasoning that their lower payouts still offer a strong yield, given their lower share price.
In addition, the increased volatility associated with the market’s decline has devalued investors’ principal, leaving them with less capital to invest, if they choose to rebalance their portfolios.
A useful, conservative strategy that actually capitalizes on the market’s volatility to lock in high dividend yields is the covered call selling technique.
The increased market volatility has increased call option premiums, giving investors the opportunity to sell high yield covered calls on many stocks, in effect giving them a one-time “double dividend”, reducing their initial investment cash outlay, and also offering them some downside protection. Since no company can cut the premium on their call options, investors using the covered call selling strategy receive an irrevocable cash payout that’s essentially an “ironclad” dividend. Indeed, the current call premiums are often giving investors higher payouts than the underlying stock dividends. So, even if the company does cut its dividend, the investor will still retain the premium from his covered call sale. In addition, a call seller receives the call premium money back into his account upon settlement, (usually trade date plus 3 days).
Covered call writing also benefits investors looking for secure dividend yields by giving them a third potential profit: capital gains. By selling covered calls at a strike price approximately 5-20% above the stock’s current price, investors give themselves the potential for an additional 5-20% profit, should these stocks rise past the strike price + covered call premium thresholds by the end of the investment term . Given the historic lows that many companies’ share prices have fallen to, many traditional value investors feel that they are buying these stocks at undervalued prices, and reason that there’s a very good chance of them rising in the future.
Covered call selling quantifies the upside limit and downside break-even point, giving you a more clearly defined trading range than if you’d just bought a stock without hedging it.
Your downside break-even point equals:
cost/share – (sold call premium you received + dividend payout)
Your maximum resale price: call strike price + sold call premium you received.
The closer your call strike price is to the underlying stock’s price, the higher premium you’ll receive, and the more downside protection you’ll gain. However, you’ll give up some upside profit potential by selling calls at a lower strike price, so, you your strategy will depend upon how bullish you are about the market and the particular stock.
WARNING: avoid selling calls more than 3-4% BELOW your cost/share, as this will cut into your profit, should the stock be called away at expiration.
copyright 2009 DeMar Marketing. Author: Robert Hauver – publisher of The Double Dividend Stock Alert, a monthly e-newsletter featuring high yield strategies for income and value stock investors. If you’d like more info about getting specific stock picks using this strategy, please visit us at www.DoubleDividendStocks.com
(The information in this article is for informational purposes only and should not be used solely for any investment decisions. Author not responsible for any errors or omissions herein or any losses sustained by third parties based on the information in this article).
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