One Way to Earn More From Dividend Stocks

Key Points

• This strategy may be suitable for those who are comfortable with an active style of investing as well as using options.
• The approach has limited downside risk but is by no means risk free.
• In saying that, substantial income can be gleaned from this method.

If you own a portfolio of dividend stocks, you might wonder how to earn more income from your investments. 

You can follow one simple strategy to unlock more income from your portfolio. This strategy involves limited risk and may also lead to appreciable upside returns.

Let’s cover this strategy and how to apply it to your account.

Covered calls

This strategy involves selling call options on the stocks you already own. Doing so can yield significant additional income through premiums paid by buyers of your options contract.

A call option gives the buyer the right but not the obligation to buy your shares at a predetermined price in the contract, also known as the strike price and before its expiration date.

Since you are selling call options on stocks you already own, your call option is' covered' by offering your shares as collateral against the potential of unlimited losses.

One caveat is that you must own a minimum of 100 shares of a stock you wish to write a call option on.

Two things can happen on the expiration date of your contract. First, if the stock is trading above your strike price, you will keep the premium, and your shares will be sold or “called away” to the buyer of your contract.

However, if the stock trades below the strike price at expiry, you keep the premium from the contract. The contract also expires worthless, allowing you to retain your shares and increase your income through the premium.

What you choose to do with your premium income is up to you, but some investors like to reinvest that premium income into buying more shares, which means they can earn more dividends and potentially write more call options.

The main risk of using covered calls is losing ownership of your shares if the stock price rises above the strike price in your options contract. This, in turn, could also lead to a large opportunity cost if the share continues to rally.

But if your stock drops in value during the contract, your biggest expense is theoretical unrealized losses that you may have incurred anyway as a buy-and-hold investor.

When to use covered calls?

A good time to use covered calls is when your long-term investment thesis on dividend stock changes for the worst. If you are no longer bullish on a company’s overall prospects, writing covered calls allows you to profit from higher premium income while waiting for a buyer of your shares. This might be a preferable line to simply selling your shares on the open market.

Of course, if the company’s stock price keeps falling, you may not get to exit from your investment.

Or you might notice, for example, that your portfolio is overweight in a particular sector, such as technology and is therefore no longer diversified. Writing covered calls will help you earn premium income and dividends while rebalancing it.

Another situation to write covered calls is during times of low expected volatility or limited upside potential.

Risks

This also ties in with the idea that you shouldn’t sell options just because you can or for the sake of the premium. Rather, getting premiums from options should complement decisions you would make anyway. 

High premiums naturally attract risky behavior, such as buying contracts with short expiration dates or having strike prices too close to the stock’s current trading levels. 

Sooner or later, investors will wish they didn’t know about covered calls if they make decisions based on premium income alone, but there are ways to mitigate these risks.

If you do not wish your shares to be assigned or “called away” to buyers of your contract, two things you can do is sell contracts that are longer in length and have a higher strike price. This will ensure you have a margin of safety. The downside is that you sacrifice some premium income in this process.