Investing In Options: Generate Income Without Dividends

| August 20, 2012 | 0 Comments

portfolio hedgingIncome investors have been left out in the cold by the Fed.

Risk-free assets like government bonds or FDIC insured savings accounts and CDs hardly pay anything these days.  And they certainly don’t keep pace with inflation. 

You simply must be willing to take on risk in order to generate income today.  This phenomenon has sent boatloads of cash that once resided in risk free accounts into corporate bonds, MLPs, REITs, and dividend paying stocks.

Put simply, investors are chasing yield.

In a recent Wall Street Journal article, the chief market strategist at AllianceBernstein said investors are paying 25% more for dividend paying stocks than those that don’t.

At this point, the dividend trade has become overcrowded.  Anytime a trade becomes this popular, it becomes overpriced.  And overpriced investments are risky.  That’s bad news for risk-averse income investors.

Now it’s not only impossible to make a risk-free return, but other investments that do yield a decent amount of income have become a ticking time bomb.  It’s only a matter of time before the value of these investments comes crashing down.

What are income investors to do?

I think selling covered calls is an excellent way to turn non-dividend paying stocks into income producing machines.  This strategy involves buying the stock and selling out-of-the-money call options against your long stock position.  Each time you sell a call option you collect income.

I wrote about it here…  Covered Calls: How To Generate Profits In A Flat Market

Another strategy you might want to take a look at is a diagonal call.  It is similar to a covered call, but it’s a much cheaper investment.  So the yield is higher.

Let’s take a look at how this would work with EMC (EMC). 

EMC is a rock solid tech stock.  They’re a huge player in cloud computing.  The stock is in a strong long-term uptrend.  But they don’t pay a dividend.

Right now, EMC trades for $26.50.  If you buy 100 shares of EMC, it will cost you $2,650.  You can sell the September 2012 $28 covered call for $0.30.  So you collect $30 and your yield is about 1.1%.

If EMC is below $28 when the option expires in September, the option will expire worthless.  You’ll keep the $30 as income.  Then you can sell another out-of-the-money call option next month and collect another premium. 

Not too shabby… 

Now let’s look at how it works with a diagonal call.  In this case, the stock is replaced with a long-term deep in-the-money call option.

Right now, you can buy the January 2014 $23 call option for $6.00.  And you can sell the September 2012 $28 call for $0.30.

It costs you $600 to buy the Jan 2014 $23 call.  You still collect the same $30 as you did with the covered call.  But since your initial investment in the Jan 2014 call is only $600, the yield jumps to 5%. 

And just like the covered call strategy, as long as the stock remains below the higher strike option, the option will expire worthless.  You get to keep the option premium as income and you can repeat the sale of another short term call option over and over again. 

Keep in mind, with both the covered call and the diagonal call, the option you sold will get exercised if the stock is above the strike when it expires. 

If EMC is above $28, you will have to sell the Jan 2014 $23 call option, buy the stock at market price, and deliver it at the higher strike price.  But this is essentially a wash because the deep-in-the money call option will move in lockstep with the stock price.   

Here’s the bottom line…

Dividend stocks and other income producing investments are overcrowded.  At this point, you’re better off using a covered call or diagonal call strategy to generate income on non-dividend paying stocks than waiting around for the bubble in overpriced dividend stocks to burst.

Good Investing,

Corey Williams

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Category: Investing In Options

About the Author ()

A former banking executive, Corey Williams is the Chief Options Strategist and co-editor of our well-known daily newsletter, Options Trading Research. Corey’s extensive experience with options goes all the way back to his days in corporate finance. It was this decade in banking where Corey discovered the most important skill an options trader can have– the ability to analyze a company or sector to determine its likely future direction. And now he’s brought this background, experience and love of options to Options Trading Research, the unique daily e-letter devoted exclusively to helping individual investors profit from the very lucrative options market.