Proponents of dividends point out the following:
- a high dividend payout is important for investors because they provide certainty about the company’s financial well-being.
- Typically, companies that have consistently paid dividends are some of the most stable companies over the past several decades.
- And it’s very important to look for companies that have made stable payouts in order to be in a position to maximize your income and return.
In our example, we will look to make $100 per month using a $40 stock that pays an annual dividend of 3.45%.
The shares required is found by multiplying the monthly income received times 12 and divide that by the share price times the yield
Shares required = 12 x $100/$40 x 0.0345, which for our example would be 869 shares.
The dollar amount needed to own those 869 shares would be 869 x 40 =$34,769.00.
For many investors this is as far as they go. But their are two major benefits of adding the option component.
We can enhance the monthly income by selling covered calls and improve our return on capital. One thing to keep in mind however is that the covered call will mean more variability of return.
So how do we set up the covered calls. First we need to make a couple of assumptions.
1. We are going to sell the covered calls about 10 times each year. And why will we do this? We will generally be selling the calls over a period of 45 days, which occurs approximately 10 times each year.
2. We want to choose the options that are the first strike out of the money that are about 2% away from the the current stock price.
For our $40 stock we would use a call option that would be 40 x 1.02 = 41. For a $40 stock the 41 cal would be just out of the money and generally carry a decent premium.
We know by now that an option contract represents 100 shares of stock. Since we need 869 shares we would need 8.69 call contracts. But we cannot write .69 contracts, so we we will round down to 8 contracts.
Furthermore, we will assume we can receive $.32 ($32) for each contract sold. With that in mind in this hypothetical example our annual cash flow from the calls would be
8 contracts x $32 credit for the calls x 50% x 10 = $1280 cash flow from the calls.
The final piece is to put this together and figure our enhanced return. We do that as follows:
Cash flow from the calls + Dividend per year/ Value of the shares = $1280 +$1200/$34760 = Return on Capital
Our hypothetical annual return would be 7.1%. These calculation are based on implementing the strategy is a cash account. If you do this in a margin account with a 50% margin requirement, the returns would be significantly higher. Remember the notional risk would still be the full price of the stock, but the lower buying power requirement would have a beneficial impact on your return on capital.
Sit down with a pencil and paper and run the numbers. And, if you have any questions, please feel free to commen, or send me a note at firstname.lastname@example.org.