Chris’ note: For most folks, 2022 has brought painful losses – not just from the bear market, but also from record-high inflation.
That’s why all week, I’ve been featuring essays from our most income-savvy experts here at Legacy Research. They’ve been sharing their top strategies for building rising streams of stock market income.
The most popular approach is to buy dividend-paying stocks. But there’s another way to boost your income from stocks… even if they don’t pay a dividend.
So, today, we turn back to Teeka Tiwari analyst Andrew Packer. As you may remember from yesterday’s Cut, he’s an income investing expert with a long track record of building reliable streams of income… no matter what markets are doing.
As he reveals below, there a little-known strategy that lets you create your own “dividend” on the stocks you already own.
Yesterday, I shared an important concept with you…
It’s something you can use to create a growing stream of stock market income over your lifetime.
It’s called yield on cost.
Some stocks pay out regular income to shareholders as a dividend.
You get a stock’s yield by dividing the dividend per share by the share price. Then you multiply the result by 100 and add a percent sign.
So, if a stock is trading at $20, and it pays a $1 dividend every year, its dividend yield is 5%. (1 / 20 = 0.05 x 100 = 5%).
But to find your yield on cost, you divide the dividend payment on a stock by your original buy price. Then you multiply that by 100 and make the number a percent.
If you buy stocks with long track records of raising dividend payments, your yield on cost will rise over time as your dividend payouts go up.
In some instances, your yield on cost will rise into double digits.
I used this strategy during the 2008 global financial crisis to buy blue-chips like McDonald’s (MCD) and the Walt Disney Company (DIS) at discounts.
I bought MCD for $55. And I’ve seen a return of 396% thanks to the rise in the share price alone.
But I’ve also been earning a rising streams income along the way.
Today, McDonald’s has a current dividend yield of 2.2%.
But my yield on cost is a lot higher.
McDonald’s annual dividend payout is $6.08 per share. And I paid $55 to own those shares.
So, my yield on cost is more than 10%.
But sometimes even the most reliable dividend-payers stop paying dividends.
That happened with another purchase I made in the depths of the 2008 crisis – Disney (DIS). It paused its dividend payments in 2020.
For many income investors, that means hitting the sell button.
But not for me. I’m still earning steady income streams from my Disney shares…
And today, I’ll show you how.
Create Your Own “Dividend”
I earn a “dividend” on my Disney shares through options – specifically covered call options.
When most investors think of options, they imagine high-risk, complicated trades.
Of course, it’s never risk-free… But selling something called a covered call on blue-chips like Disney isn’t so risky or tough.
Calls are bullish “side bets” on a stock. You profit when the stock price goes up.
Covered calls are options you sell on stocks you already own.
And when you sell a covered call, you get an upfront payment straight to your brokerage account. It’s called a premium in options jargon.
You get to keep that money no matter what happens with the trade.
And if you limit your sale to one contract for every 100 shares you own, you’re covered.
Here’s how that works…
First, pick a target price above the current share price. This is called the strike price. You should set it at a level the stock is unlikely to hit before the option contract expires.
A good rule of thumb is the strike price should be 10% to 25% higher than the stock’s current price.
Then you pick an expiration date about two to three months out.
Options lose value over time as they approach expiration – like the “best before” date on a carton of milk. So, I usually choose an expiration two to three months out to give me enough time to sell them before they “go bad.”
Then you pick up your upfront payment. This hits your brokerage account as soon as you sell your option. And you keep it, no matter what.
Once you’ve sold your call, one of two things will happen…
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The stock trades below your target when the option expires – If this happens, you keep your stock and the upfront payout you’ve pocketed.
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The stock trades above your target when the option expires – If this happens, you keep the upfront payout but sell your stock to the call option’s buyer at the strike price.
Like with every strategy, there are some risks to selling covered calls.
If the stock goes to the buyer of the contract, you’ll miss any price appreciation above the strike price.
So, if you love the stock you’re selling covered call options on, make sure to set the strike price far enough away from the share price.
Your premium payment will be a bit lower. But your chances of losing the shares will be, too.
11.8% Income Boost
As I mentioned, Disney suspended its dividend in early 2020. And hasn’t reinstated it.
But instead of selling my shares, I created my own “dividend” on the stock.
And I’m still collecting those payments two years later.
Take the October 2022 $135 calls on DIS for $2.40 a share. This contract has expired. But it’s a good example of what I mean…
DIS was trading at about $116 a share at the time. So, the strike price of $135 was 16% higher than the share price.
Blue chips like Disney don’t often see 10% rallies in two months. That meant DIS was unlikely to hit the strike price.
Each options contract covers 100 shares. So, by selling those covered calls I could have made $240 a contract.
That’s a 1.9% return in just two months.
That may not seem like much. But the dividend yield on the S&P 500 is 1.7% a year. So that’s a nice chunk of income from a low-risk trade in a sixth of the time.
And if I could make $2.40 a share in extra dividend payments from Disney every two months, that would be $14.40 a year.
That’s a 11.8% return on top of the gains from a rising share price.
Again: Low risk doesn’t mean no risk.
There’s a chance Disney will continue to go higher. It released solid earnings. And investors like its plan to raise prices on its streaming service, Disney+.
If the share price goes above the strike price, I’ll lose my DIS shares along with any gains above the strike price.
But I’ve been using this strategy routinely over the past two years to churn out income on DIS… and my shares haven’t been called away from me yet.
Bottom line: If a stock doesn’t pay a dividend, consider selling covered calls on your shares.
I’ve used this strategy to make back more than I spent on my Disney shares.
Good investing,
Andrew Packer
Chief Analyst, Palm Beach Letter