Now more than ever many investors need consistent income without a threat to their nest egg. There is a path for this, and it coincides with the best general investment strategy:
Take what the market is giving you!
The current market gift is high volatility which makes equity options very expensive. This has not slowed down the small traders who are speculating by buying options. The pros are selling them, and you can safely join in.
I described the concept in this post The Quest For Yield, Part 8: Find What Is Working. I reviewed this and other methods in my “Yield Quest” series from eight years ago.
The program, which I call Enhanced Yield, consists of buying a good dividend stock and selling a call against the position. While there are many dividend programs and many covered call programs, there is a powerful synergy from putting them together. There is also skill in choosing suitable stocks and the right call to sell.
Readers have asked that I resume the “Dividend Boost” series. There were many good reader questions, and I will take up the position management issues in future posts. For now, I will review the basic technique using a current example.
Choosing a Suitable Stock
The best stocks for enhancing yield have the following characteristics:
- A reasonable dividend – 2.5% or more is fine.
- A good balance sheet.
- A reasonable payout ratio, providing confidence that the dividend can be maintained.
Limited downside risk.
- A cheap stock on a P/E basis.
- Evidence of technical support.
- Liquidity in the options market, avoiding very thinly traded stocks.
We do not care about the immediate chances for an upside move. We do not care about the “organic” earnings growth versus share buybacks. We do not care if the stock is currently out of favor or seems boring.
We seek a safe platform for selling calls. Wherever others see a “value trap,” we see a candidate for this program.
For valuation, I use FAST Graphs to verify that the current price is attractive.
Stock Price Chart
Technical support is something of a mystery in the current market environment, but we should try to do our best. I did not draw any lines on the chart below, but my approach is simple. At any price where there has been a lot of trading, we can expect some market participants to have a trading interest. On that basis, we are in an area of support right now and can see another at 45 or so. I aim for support at about 8% below the current price, but that is difficult in the current market.
CAH Weekly Chart
Which Call to Sell?
The next step is to choose the right call to sell. There are scores of choices, but only a few are good candidates. Here are the key characteristics (which we will discuss more in future posts).
- Reasonable absolute premium.
- Good annualized yield.
- Capture the dividend if possible.
- Short time period, for rapid time decay. This takes more work but generates better returns as you can see from the chart below.
Which Call To Sell
Here are the closing option markets for acceptable call sales, focused on interesting strike prices in both May and June. We sell calls a bit above the market to allow for a potential stock gain.
Dividend Gain Table
We plan to open this trade tomorrow. The exact choice of call will depend on market circumstances. Based upon the closing prices above, I like selling the MAY 52.5. The premium is very large for only two weeks – 3.47% even if the stock price does not change. If the stock is called away, we make a bit more. I do not have an expectation for the stock price in two weeks, so I am happy either way. If the options go out worthless, I will next sell JUN calls. If the stock gets called away, I will book a solid two-week return and move on.
Putting It All Together
This strategy works best if you have several positions in diverse sectors. I currently use 14 positions, with no more than two in a single sector.
Most of our cash flow (80%) comes from selling calls. The expected 9% cash flow means we can take 5% yield and reinvest the rest. The yield payout comes from the dividends and call sales, not from selling your stocks. In that sense, it is like a regular dividend program. An advantage is that if the underlying stocks decline, the reinvested yield increases your position size. You are “buying low.” When stocks are sold (closing above the target price) you are “selling high.”
Can It Work for You?
If you are an income investor, you might give this a try with a small, starter position. But beware. Here is what I wrote almost eight years ago:
Here is the qualification test — hardly anyone can pass it!
You cannot look at your brokerage statement, the daily mark-to-market, the monthly mark-to-market, or anything else. You are an income investor.
This is what you would do with a bond portfolio. You buy expecting to collect the coupon and the principal at maturity. It is a simple test, yet a difficult one. The bond investor does not worry about daily marks.
Psychologically, people cannot do this with stocks.
I would now add a second qualification: Do not focus on individual trades. This is a portfolio that will include some winners and some losers. The real test is whether you are meeting your income goals.