When investors get serious about really supercharging their income, there are a few things they can do.
One easy way to goose a little extra income out of a dividend-paying stock is to use a dividend-reinvestment plan, commonly known as a DRIP. Many companies give investors a bonus of up to 5% for taking their dividends in the form of additional shares. A DRIP is an easy way to turn a 5% payout into one worth 5.25%.
The other way for investors to really increase their income is to go up the risk spectrum. There are dozens of Canadian stocks that yield in excess of 10%. Many of these have what I view to be sustainable yields, but many more do not. And even the ones which do offer solid dividends could easily get hit by some unforeseeable event. If a stock pays 95% of its earnings out to investors, there isn’t much room for error.
There’s another way investors can really ratchet up their yields. This method seems complex, but in reality it isn’t so hard. It offers a safe way for investors to get 10%, 15%, and even 20% yields.
Intrigued? Read on.
The income secret Bay Street doesn’t want you to know
Many investors view the option markets as nothing more than gambling. After all, collateralized debt obligations and credit default swaps are really just fancy options, and we all know what happened with them.
So, many investors stay far away from options, even though basic option strategies aren’t very complicated. Take call options for instance. Regular investors can do one of two things with a call option. They can either buy a call–which gives them the right to buy a certain stock on a certain date for a certain amount–or sell a call, which means they’ll be forced to sell at a certain price on a certain date, provided the price is higher than the price of the call option.
Let’s look at a real life example. The March 19 $92 call option for Canadian Imperial Bank of Commerce (TSX:CM)(NYSE:CM) shares currently trades hands at $1.74. So if an investor bought this call, they’d have the right to buy CIBC shares at $92 in March. If shares go up to $94 by that time, the investor would make $2 on a $1.74 investment.
It’s easy to see why this would be popular with speculators.
On the other side of this trade, you’d immediately receive $1.74 for taking on the responsibility to sell at $92. So what many investors do is buy the underlying stock. The current price is $90.34, which means if CIBC closes above $92 on March 19, an investor would be guaranteed a modest profit on any shares bought today. If not, the option just expires, worthless.
But remember, an investor who owns shares immediately gains $1.74 per share in income. So, in effect, an investor is trading potential upside for additional income today.
Assuming the same conditions exist two months from now, an investor can do the same thing again, and then again. Pulling off this move six times a year would bring in a total of $10.44 annually in option income. That alone is a yield of 11.6%.
CIBC also pays a great dividend with a current yield of 5.1%. Combine that with the option income and an investor could be taking home 16.7% annually. Based on a 100-share investment of $9,034, that’s a total income of $125 per month. Spread that out over a half a dozen different stocks, and that’s the kind of income that can really make a difference.
As the old saying goes, there’s no such thing as a free lunch in finance. By writing covered calls, investors are trading potential upside for income now. That might be a bad deal for someone looking for long-term capital gains, but for someone who wants income now, covered calls can be a great option.
