Design Your Own Dividends

 | Dec 08, 2011 | 1:00 PM EST  | Comments
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Stock quotes in this article:

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ibm

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This seesaw market has left many investors seeking ways to generate portfolio income in a low interest rate world. The current uptick in stock prices during the fourth quarter has reduced dividend yields. In August, one could have picked up shares of Intel (INTC) below $20, and gotten both an undervalued stock and a 4.5% dividend yield.

Investors who were fortunate enough to take advantage of that opportunity now have pocketed a 25% gain in the share price appreciation and are still collecting nearly 5% in an annual yield.

Intel and other blue chips still offer investors yields greater than 3%, which is quite attractive in today's world. But through the sale of covered calls, call options on stocks you own or are willing to own today, investors have the opportunity to generate portfolio income at annual rates many times more than today's best blue chips yield.

Consider the payment processor MasterCard (MA), now trading about $375 a share. Despite the strong share run-up in 2011, 2012 looks like another solid year for MA as consumers continue to prefer the use of debit and credit over cash. One can sell the MA April 2012 $430 calls for around $10. (I ignore commissions here for simplicity).

If MasterCard is trading below $430 come April 21, 2012, the sold call expires and the investor pockets the $10 premium. That premium represents a 2.6% yield ($10/$375). Since your carrying time is four months, the annualized yield is 7.8%. If MA shares trade above $430, the shares are called away, in which case the effective sale price is $440 (exercise price plus option premium), representing a 17.3% gain in four months, or 52% annualized.

IBM (IBM) is another great candidate for creating a synthetic dividend. Shares in Big Blue currently trade for $193. The April 2012 $210 calls can be sold for $4.40. Over the four-month holding period, that represents an annualized yield of 6.9%. If shares are called away in April because the stock trades at $210 or higher, the annualized holding period return comes to 33%.

Everyone's favorite stock, Apple (AAPL), can also produce a great covered call income stream. Selling the March 2012 $425 calls today at $13 is equal to 3.3% of today's share price of $392; over the three-month holding period, this equates to an annualized yield of 13.2%. If Apple shares trade at $425 between now and the March 17 expiration date, the annualized capital gains yield is 47%.

The immediate risk is that the underlying stock price declines, in which case the option premium mitigates your losses by reducing your effective purchase price. Yet the outlook for names like MasterCard, its rival Visa (V), IBM, Apple and others, such as Chipotle Mexican Grill (CMG) looks favorable and allows attractive opportunities to write calls at this juncture. While it may be tempting to write covered calls on financials today, their valuations are depressed. If the mood for financials turns better in 2012, share prices could surge drastically, and owning a covered call could leave a lot of upside on the table.

The use of covered calls for income-generating purposes should be applied prudently; select quality stocks that you are comfortable owning in case the price dips and generally on companies with favorable outlooks. In today's low-yield world, covered call yields can produce significant yields.

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