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Supersizing Your Annual Dividends & Generating Additional Income by Selling Covered Calls

I describe how I implement a covered call strategy to my overall investment strategy to generate additional income.

Dividend investing allows an individual to generate a consistent income stream from investing in individual equities or funds. Many investors look to dividends to either supplement their current income or offset the loss of income when they retire. I have a comprehensive investment strategy that I designed to meet my future objectives. Dividend investing represents one segment of my investment mix as I am investing in both individual equities and funds to create a continuous income stream. Every dividend I collect gets reinvested so I can utilize the powers of compounding to my advantage.

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What if there was a way to increase the amount of annual yield an investment generates? Regardless if an individual equity or fund is generating a forward yield of 2%, 5%, or 8%, there is a method to supersize the yield your capital is generating. Many investors have heard about options, but few have taken the time to understand them, and even fewer have tried to implement an options strategy to augment their investing. I utilize a covered call strategy to increase the amount of income some of my investments generate and generate income from investments that don't pay dividends to their shareholders through selling covered calls. I will describe what a covered call is and how I implement a covered call strategy to my investment strategy to generate additional income.

What is a Covered Call?

Before implementing this strategy, I suggest doing a fair amount of research and making sure that you understand every aspect of call options. I will link a video from the Everything Money channel on YouTube here, where Paul Gabrail does an excellent job of breaking down puts and calls. I only sell covered calls in full disclosure, and I do not sell naked calls where I don't own the underlying asset.

For people unfamiliar with options and calls, I will describe what a call option is and what a covered call is. A call option is a contract that provides the buyer of the option the right to purchase an asset (stock, bond, commodity, etc.) at a specified price within a specific period. When looking at a call option, there are three main components: the option expiration date, the strike price, and the last/bid/ask price. In the realm of stocks, 1 option contract is the equivalent of 100 shares.

  • Expiration date
    • This is the date when your option expires. You must either sell or exercise your option by this date.
  • Strike Price
    • The strike price is the price that you agree to either buy or sell an equity for at a later date which is defined by the expiration date
  • Last / Ask / Bid
    • This is what the option contract is currently trading at on a per-share basis
    • If you see .03 you must multiply by 100 as the option contract is for 100 shares, so if you see .03 on the ask it's the equivalent of $3

A Covered Call is known as a transaction where an investor owns shares of an equity and sells the equivalent amount of call options on that equity. Hypothetically if an investor owned 100 shares of company XYZ, they could sell 1 call option on XYZ. This is referred to as a covered call because the investor owns the underlying shares which the call represents. In essence, the trade is covered because you're backing the transaction up with your shares.

How I Use Covered Calls and An Example of a Covered Call Option I Am Considering

When it comes to generating additional income from covered calls, I am very selective on the companies that I implement this strategy with. With dividend-paying investments, I want to pick boring companies that I believe will trade sideways throughout the duration of the call option. In my mind, I want the call option to expire worthless so I can keep the premium I was paid, keep my shares, and repeat the process. I never sell call options on shares I don't own because I am not looking to tie up cash as collateral against the call option. Since I own the shares and they are just sitting in my dividend account, I am willing to sell covered calls on them to generate additional income.

AT&T (T) currently pays a dividend of $2.08 per share for a forward dividend yield of 7.65%. This is a tremendous yield, and I can increase the forward yield by selling covered calls. The 52-week range for AT&T is $26.35 - $33.88, and AT&T hasn't traded above $30 since May of 2021. The investor sentiment on T is poor, making this an interesting candidate to utilize a covered call strategy on.

(Source: Yahoo Finance)

(Source: Yahoo Finance)

I like going a few months out on the covered calls, and I look out of the money. In the example above, any call options that are shaded in blue are considered out of the money as AT&T would have to see share appreciation to reach the strike price. In this example, the expiration date is 1/21/22, which is just under 4 months into the future. I am currently interested in the $30 strike price for $0.19.

Here is how this play works. Hypothetically if I own 100 shares of AT&T, I could sell 1 covered call as each call option is the equivalent of 100 shares. If I was to sell 1 covered call at a strike price of $30 for $0.19 with an expiration date of 1/21/22, that would mean that I just sold the right for someone to purchase my 100 shares from me on or before 1/21/22 for $30 per share. This person would have paid me $0.19 per share or $19 in premium for the right to buy my shares at $30 per share. While this contract is open, any dividend that AT&T issued I would collect as I still own the shares. If AT&T finishes at $30.50 on 1/21/22, I would be obligated to sell them to the person who bought my call option for $30 per share even though they were trading at $30.50. If AT&T is trading at $29 on 1/21/22, the call option will expire worthless, and I would keep my shares and keep the premium of $19 that I was paid for the right to buy my shares.

The best-case scenario for me would be for AT&T's shares to trade under $30 on 1/21/22 and expire worthless, so I can keep both my shares and the premium I was paid. If that were to occur, I could repeat the process again and sell another call option a few months into the future. This turns many people off because it limits your upside potential. If AT&T was trading at $35 on 1/21/22, you would be obligated to sell your shares for $30 and lose out of $5 of upside per share. Therefore I like using boring companies that I own or companies that are trading sideways or down. Even though I believe AT&T is undervalued, it's an interesting candidate for a covered call strategy as its chart is stuck in a downward trend, and investor sentiment is mixed to negative. Keep in mind this could change, and shares of AT&T could go up. You have to be ok with the chance of losing your shares, so if you're going to implement this strategy think about what you would be willing to part with the shares for in case you have to cross that bridge. I have had shares of Energy Transfer (ET) called away from me in the past, but I was willing to part with them at the strike price I locked myself into.

Looking 4 months into the future, the 1/21/22 call option would allow me to complete 3 covered calls over the course of a year if they all worked out in my favor by expiring worthless. Let's keep the numbers the same on each call option. AT&T pays a dividend of $2.08 per share. If you were to sell three covered calls over the course of a year and collected $19 of premium each time you sold a covered call you would collect $57 in premium from the covered calls. Your 100 shares would generate $208 in dividend income prior to compounding. By using this strategy, and if it worked out as I described, your 100 shares of AT&T would generate $265 instead of $208. Assuming that shares of AT&T traded sideways, this would increase your forward yield of 7.67% to 9.77% based on its current share price.

Covered calls aren't for everyone, and I recommend doing a lot of research to gain a solid understanding of how options work. For people who find this strategy interesting but don't want to spend the time learning and implementing a covered call strategy, Global X has created three ETF's that are based around a buy-write covered call strategy to generate yields that exceed 10%. I previously wrote an article for named Generating a 10% yield from combining three ETFs from Global X. If you are interested in letting a fund manager do the work while you sit back and collect large distributions, QYLD, RYLD, and XYLD may be an interesting addition to your income-producing portfolio. If you are interested in squeezing every bit of yield out of your current investments, look into covered calls as they can increase your annual yield substantially for doing minimal work. 

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