As a brief overview, this strategy includes buying a stock and then selling call options against the position. For selling the call option contract, we collect a premium, and in return, become obligated to sell our stock at the option's strike price, assuming the market price is above that level before the option expires.
As a general rule, I prefer to set up covered call trades that will expire in four to eight weeks. This allows us to sell calls at an attractive price and still close out our trades for profits relatively quickly. Typically, we can expect to book a profit of 3% to 5% over the time period, which means that our per-year returns are in the neighborhood of 25% to 35%.
Dividends Add Firepower To A Covered Call Strategy
Covered call trades are powerful enough on their own. But when you add in the extra income from a dividend payment, the annualized returns get even more exciting.
Let's consider a covered call scenario in which we would typically expect to receive 4% over a 45-day period. Using a back-of-the-envelope calculation, we can say that this trade has a per-year rate of return of 32% (4% divided by 45 days multiplied by 365 days in a year).[More from StreetAuthority.com: When Is Risk Your Ally In Income Trades?]
Now, what happens if the stock pays a 1% dividend on day 30 before the call contract that we sold expires?
There are essentially two ways that this scenario will play out:
1. We receive the dividend payment.
Since we are buying stock and selling the call contract, we remain the technical shareholders until the owner of the call option contract actually exercises their right to buy stock from us. So if that right is not exercised, we continue to hold the stock and we receive the dividend just like any other shareholder would.
2. Our stock position is called away early.
The owner of the call contract has the right to buy stock from us at the strike price at any point in time before expiration. If the stock is trading well above the strike price, it would be in the other trader's best interest to exercise his right early and buy the stock from us so that he can receive the dividend payment.
In either case, our covered call trade benefits us. We either receive the dividend payment (adding to our total income), or we are able to close out our trade early, giving us the same return as expected, but in a shorter amount of time.
Looking at the first situation, the addition of a dividend payment can dramatically increase our per-year rate of return. Now, instead of generating a 4% return over the 45-day period, we are accepting a 1% dividend payment and bumping our return to 5% over the same time period. This nets out to a per-year return of more than 40% -- well above our target rate of 25% to 35% per year and much more than the traditional dividend investor can make.
On the other hand, the second situation is actually just fine too. If the owner of the call option exercises his right early, the trade will be closed out for maximum profits (we still generate our 4%), but in a shorter time period. This means that we can more quickly set up our next covered call trade with our freed-up capital, compounding our gains more quickly and potentially reaching a higher per-year rate of return as well.[More from StreetAuthority.com: ]
One thing to keep in mind is that option prices on volatile stocks are typically higher than on more conservative stocks. For this reason, we can generate more income from the volatile stocks because we sell our call options at a higher price, but we also take on more risk.
Action to Take --> Using dividend stocks, which are generally less volatile than a typical growth stock that does not pay a dividend, can be a great way to boost returns on the covered call strategy while still keeping your level of risk relatively low. The income from selling covered calls and the dividend payments also will help to offset any losses in the stock should that occur.
This article was originally published at ProfitableTrading.com:
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