Is there a simple method to leverage dividend yields without magnifying your risk? Instinctively the answer would be no, you cannot increase return without a comparative increase of risk. Usually that would be true. Let me fill you in on a little secret. It is not complicated and even a novice investor can do this with a little training. This trick is suitable for dividend investors who are basically in the market for the dividends and who are nervous about falling share prices or a future market crash.
The Big Juicy Dividend Secret
Ready for the simple secret? Here it is…drum roll please…deep in-the-money covered call options. If you are unfamiliar with covered calls, please read up on covered calls. In a nut-shell, you sell options on stock you own. The options will allow someone to buy your shares before a certain date at a certain price. You collect a small premium for selling such a contract.
There are compelling reasons why we want to use covered calls with our dividend stocks.
- The share holder (you) retains the right to collect the full dividend
- Selling covered calls will lower the average cost per share – meaning bigger dividend yields
- Selling covered calls will remove risk of a market drop – you don’t lose if the stock goes down
Are you starting to see the advantage? The secret is to sell call options on stock we own with a strike price as low as possible (deep in-the-money) and an expiration date as far away as possible. Let’s look at an example of how this would work.
Leveraging Verizon’s Dividend
We will use Verizon (ticker symbol: VZ) for our example.
As I write this article the dividend yield is 4.85%. The market is over-valued, we are days away from a major US election and they recently acquired Yahoo. Perhaps all of this makes you nervous about buying right now. So this is what you do…
Buy Verizon at $47 per share, which is the market price. Sell the rights to the stock as deep in-the-money as possible and as far away in time as possible. Today is November 4th 2016 and we can sell call options that expire in January 2019 at a $30 strike price.
This is what we have accomplished:
- We purchased stock in Verizon
- We sold the rights for someone to purchase the stock by Jan 2019 if prices are at or above $30 per share
- Selling the option will return to us $17/share in stock price plus a small premium
- We still own the stock and still receive the full dividend
- We do not profit if the stock goes up
- We do not lose if the stock goes down provided prices stay above $30 per share
Ruminate on this for a moment longer… the dividend coming in will be $2.31 per share over the next 12 months. Only the shareholder is entitled to the dividend, not the person who purchased the options contract.
Your cost of ownership is $30. Yes, you initially purchased it for $47/share but the $17/share was returned to you when you sold the covered call option.
- $2.31 dividend per share / $30 cost per share = 7.7% dividend yield
You are on track for collecting a dividend premium of 7.7% annually. The share price can drop from $47 to $30 and you will not incur a single penny of loss. To put that another way, the stock can shed 36% of its value and you lose nothing because you essentially own the first $30 of the stock only.
As you can see, the deeper in the money your options are, the better leverage you will get and the less market exposure you will have.
The Challenge of Leveraging Dividends
But it isn’t all rainbows and chocolate cake. There is a challenge. The market is anything but long-sighted and patient. Most people live for the now. It’s why this article seems long-winded. It’s why we have High Frequency Traders. It’s why you can buy and sell weekly options instead of monthly. It is why you will have difficulty selling such long-range options that are so deep in-the-money.
Look again at the chart for Verizon options. There is very little open interest and volume in the $30 contracts we want to sell. You will need to be patient as your market is smaller and slow-moving.
Another risk is having your stock called away early. This happens when stock either goes up a little and the option holder wants to lock in a gain, or the price goes down and the option holder is nervous and sells the contract. Or for various other reasons. If this happens, you are no longer the shareholder and you do not collect your leveraged dividends. To minimize this happening to you, make sure you get a premium for selling your covered call options. Don’t sell your contract for $17 per share in the example of Verizon. $18 would be better. This gives you $1/share of premium against your cost of ownership which is $30/share. If the person called away the stock early, perhaps after 2 months, you get 3.3% return on your capital. So the more you get in an options premium, the less likely you are to have your stocks called away early.
And that’s it! As long as you are patient and diligent, you now know the secret to leveraging your dividends while lowering your risk to a falling market. Happy income investing.