Many investors have turned to a dividend strategy as a way to generate income in today’s low interest rate environment. Unfortunately, most high-dividend strategies are relegated to specific sectors, such as utilities or real estate, which limits diversification and access to high-growth opportunities in tech and other sectors that tend to pay low or no dividends.
Covered calls provide a great way to both increase income from any stock portfolio and diversify income portfolios to more sectors. When used in conjunction with dividend-focused portfolios, the popular option strategy is a highly effective way to boost income to levels that aren’t possible with dividends alone and benefit from greater growth prospects.
Let’s take a look at the rise in dividend investing and how covered call strategies can increase portfolio income and open the door to new opportunities.
The Rise of Dividend Investing
Many investors turned to dividend stocks to generate an income in the aftermath of the 2008 financial crisis. While the stock market began recovering in March 2009, bond yields have largely fallen as governments have struggled to reignite inflation. Investors seeking income have been forced to look at either riskier bonds or dividend stocks as an alternative.
Treasury Yields Over Time – Source: St. Louis Federal Reserve
Most dividend investors focus on stocks that pay a 5% or greater yield with a strong balance sheet, acceptable payout ratio and a history of increasing payments. In most cases, the issuers that fall under that umbrella include utility operators, energy pipelines, real estate investment trusts and other companies with predictable recurring income streams.
Investors that prefer a hands-off approach can also purchase dividend-focused exchange-traded funds (ETFs) and mutual funds. These funds hold a diversified portfolio of dividend-paying stocks and don’t require active portfolio management. Funds may also offer monthly dividend payments that may be attractive to some income investors.
Some popular dividend-focused ETFs include:
- Vanguard Dividend Appreciation ETF (VIG)
- Schwab U.S. Dividend Equity ETF (SCHD)
- SPDR S&P Dividend ETF (SDY)
- iShares Select Dividend ETF (DVY)
When choosing between different funds, it’s important to take into account their expense ratio, since it can have a big impact on returns over time. Investors should also carefully consider the fund’s market capitalization and daily volume as these factors could influence liquidity—or the ability to enter and exit positions at a good price.
Expand Income with Covered Calls
A covered call is a popular option strategy that enables investors to generate an income from a long stock position by writing a call option against it. When writing the call option, the investor receives an upfront premium payment as income. The only obligation is to sell that stock if the price rises above the option’s strike price or buy back the option to keep the stock.
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Rather than focusing on utilities, energy pipelines and a select number of high-dividend stocks, covered calls enable investors to expand their universe to other blue-chip names and still generate an income equivalent to a 5% or higher dividend yield. This makes it easier to build a diversified portfolio that could have more income potential than simply a dividend strategy.
As with dividend-paying stocks, there are also funds focused on covered call strategies to generate an income. These funds typically hold a particular index, such as the NASDAQ 100 or S&P 500, and write covered call options against the positions to generate an income. Others focus on maximizing income by writing covered calls against high-dividend stocks.
Some popular covered call ETFs include:
- Global X NASDAQ 100 Covered Call ETF (QYLD)
- Amplify CWP Enhanced Dividend Income ETF (DIVO)
- Global X S&P 500 Covered Call ETF (XYLD)
- Invesco S&P 500 BuyWrite ETF (PBP)
As with dividend-focused funds, investors should carefully consider the expenses and liquidity of these funds. Covered calls represent a more involved strategy than simply buying and holding an index of stocks, so the expense ratios associated with these funds are often higher than conventional passively managed index funds.
Adding Covered Calls to Your Portfolio
Many dividend investors prefer to manage their own portfolios in order to reduce expenses and select stocks to maximize income. While the covered call strategy is one of the most popular option strategies, there are some important nuances to understand for dividend investors that want to take a do-it-yourself approach to portfolio management.
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For example, some common questions include:
- What stocks are best for covered calls?
- What strike price and expiration should you choose?
- What should you do if the stock price rises?
- What should you do if the stock price drops?
- How much should you allocate to one stock?
For dividend investors, the best candidates for covered calls are companies with a 2-3% dividend yield rather than those yielding more than five percent. These companies are often more fundamentally sound with decent growth prospects rather than riskier companies that have fallen in value. It’s also a good idea to avoid covered calls that expire right after earnings dates or other volatile time periods.
The Snider Investment Method was built to answer these questions and maximize portfolio cash flow. For example, we use a proprietary SIM Score to measure price volatility and reduce the number of positions that experience a significant drop in price or prolonged periods where options cannot be sold as well as strict diversification and solvency rules to minimize risk.
The Lattco Automated Trading Platform – Source: Snider Advisors
Snider’s Advisors’ Lattco trading platform makes it easy to screen for opportunities using the Snider Investment Method, automatically placing trades and managing your portfolio. Trades are automatically identified across the option chain and orders are suggested in a pre-filled form that you can submit in a few clicks. Investors interested in covered calls can also use our free covered call screener to help generate ideas.
Sign up for our free ecourse to learn all about covered calls or explore our asset management options for a hands-off approach.
The Bottom Line
Dividend investing has become a popular way to generate portfolio income in today’s low interest rate environment, but unfortunately, opportunities are often limited to a handful of slow-growth sectors. Covered calls can help boost portfolio income and open the door to new opportunities in higher growth areas of the economy.
If you manage your own portfolio, the Snider Investment Method can help you add covered calls to your existing portfolio and generate more income.