As many of you know, I am a huge proponent of dividend growth investing and my primary investment focus is top-quality dividend growth companies. Dividend growth investing provides a growing stream of cash flow that I will be able to use to fund my living expenses later in life, without having to sell my shares! By introducing covered calls to your investment plan, you can double your dividend or more!
Typical dividend growth companies can provide 2-5% yields and dividend growth of 3-15% each year, on top of capital appreciation. With a long enough timeline or enough money invested, these investments can provide all the income you need.
That said, there are conservative strategies available to dividend investors that can help accelerate the accumulation of shares to grow your dividend stockpile.
One of my favorite strategies is writing covered calls on my existing dividend holdings. I call this method the rocket fuel for dividend growth. With this method, you can effectively “Double Your Dividend” or more.
What are Covered Calls?
For those who may not be familiar, a covered call is a type of options contract in which you as the holder of shares of a company can sell a contract to an unknown person to sell your shares at a price you determine in a timeline that you determine. As the seller, you are in control of the contract details. You set the price, you set the contract length, and you get to agree to the amount of income you are willing to accept for writing this contract.
The buyer of your covered call contract will pay you cash upfront for the right, but not the obligation, to buy your shares from you during the contract period at the price agreed on. This cash paid is called premium.
This premium paid to you from the buyer is how you get the income that doubles your dividend. I will provide examples later on. You get paid this cash immediately, and you can use this cash for whatever you want, either use the cash or reinvest it in more dividend stocks!
Covered Call Outcomes
There are three basic outcomes from doing a covered call option contract.
1) The stock price increases but never gets to the contract price in the set timeframe = you keep the premium and your shares and you are able to write another contract.
2)The stock price goes down = you keep the premium and your shares and can write another contract.
3) The stock price goes over the contract price, the buyer of the contract can exercise their right and force you to sell your shares to them at the agreed upon price. You will get the contract cash value of the shares and can use that money to buy back the shares on the market or use the money to buy something else.
In all three scenarios, you keep the premium. If you set up the contract correctly, even if the stock goes up and gets exercised, you still gain from the price appreciation up to the contract price!
How to Double Your Dividend
Ok, this sounds great, but what does this look like and how can I double my dividend, you say? I will show you.
Options contracts can last for days, weeks, or months. Since you are the seller, you get to pick which timeframe you want to obligate yourself to. As dividend growth investors, we want our dividends so you will not want to write a covered call contract if it is going to overlap on the ex-dividend date, which is the date we need to own the stock in order to get the dividend.
So that leaves 48 weeks (52 weeks – 4 ex-dividend dates) that we can write options contracts on, since even if the option gets exercised, we would have time to buy back the stock to receive the dividend.
Here is a quick example:
You own 100 shares of Coca Cola (KO).
KO is currently valued at $60.93 (1/19/2022)
The dividend paid by KO is $1.68 per share per year, yield is 2.76%.
You want to double your dividend so your goal is to obtain an additional $1.68 per share per year by writing a covered call options contract
Looking at the options contract available today, you could write a contract to sell your KO shares on or before January 28th (9 days) for $63 each. This means that if the price of KO goes over $63 during that time, the buyer could exercise their right and force you to sell your shares to them at $63, even if the market price is higher.
By taking on this contract obligation, the buyer is going to pay you around $0.08 per share, or $8 total (100 shares x 0.08). You are getting $8 for a 9 day contract. Since you are trying to double your dividend, we would need to sell a contract like this 21 times during the year. This would give us an additional $1.68 in premium, plus the dividend we already get, to equal $3.36, which would be an equivalent yield of 5.5%! You just doubled your dividend. If you sold a similar contract more than 21 times a year, you would make even more.
Risks of Covered Calls
So you might be saying, that is great, but what is the risk of the stock price going over $63 during that time period.
An easy way to get a good statistical probability of that happening is to look at something called Delta. Delta is an approximation of the chance that the contract will go in the buyer’s favor. A Delta of 0.10 means that there is an approximate 10% chance that the stock will go over the contract price for that time period.
If the buyer has a 10% chance, that means you as the seller have a 90% chance of the price not going over the contract price during that time. 90% is pretty good odds to me. In the covered call contract above for KO, the Delta was 0.10609, so the odds are that I will keep my shares. The lower the Delta, the better your chances are, but the less premium you will receive. A Delta of 0.50 means there is a 50.50 chance of the contract going in your favor.
Some more examples:
CSCO is $58.66, has a dividend of $1.48 (yield of 2.48%)
The covered call contract expiring January 28th at a price of $62 would get you $0.07 in premium per share ($7 total) for a 9 day contract. The Delta is 0.09267. To double your dividend you would need to do this 22 times a year. If you picked a longer contract timeframe or were willing to take lower odds (say a delta of .0.20 or more) you would get a larger premium,
XLF is an ETF that tracks financial companies.
XLF is $39.83 and has a dividend of $.64 (yield of 1.6%)
A covered call contract expiring January 28th at a price of $41.50 would get you $0.10 per share ($10 total) for this same 9 day contract. The Delta is 0.12601, so a 12% chance that the price goes over your contract price. To double your dividend you would have to do this contract 7 times a year.
How to Double Your Dividend with Covered Calls
The possibilities are endless, you have the control and have to decide how much risk you want to take, but generally this is a very conservative approach to getting additional income from your dividend stocks.
Some notes to remember:
- If you are doing this in a regular brokerage account, the options premium received is taxed at your regular tax rate, and if you have to sell your shares, any capital appreciation will be taxed. If you do this in an IRA, you will not owe any taxes.
- You are writing a contract, you are obligated to comply (there are strategies to avoid assignment) if the price goes against you. You may lose your shares.
- Always sell a contract that the price is over your cost basis. If you are obligated to sell your shares, you don’t want to take a loss on the stock.
Covered call writing on my dividend stocks has provided me with thousands of dollars in extra money that I use to buy more dividend stocks, increasing my dividend income and accelerating my dividend stockpile.