Here's a way to increase your income from dividend stocks

By Philip van Doorn

An active strategy using covered calls - or ETFs or funds that make use of them - can increase your investment income while reducing your risk

Many investors in the stock market are looking for income in addition to growth. They might gravitate toward stocks with high dividend yields, or they might take the approach of holding stocks of companies that seem likely to continue growing their payouts at a good clip. But there is another way to increase income from stock (or stock-fund) investments: writing covered call options.

You might already be familiar with the strategy. You might be turned off instantly by the word "options." But in the case of covered calls, you can earn additional income, which can reduce your downside risk from equity investments. There is a price: You give up some of your upside potential. Whether or not it is worth giving up some upside depends on how important additional income is to you.

At this time, there are plenty of ways for investors to generate decent levels of income. For example, 1-year U.S. Treasury bills BX:TMUBMUSD01Y yield 5.12%, and the interest paid is exempt from state and local income taxes. But you are locked in for only one year, and the Federal Reserve may begin to reduce short-term interest rates in the meantime. And longer-term Treasury yields are lower. If you go out to a 5-year Treasury note (BX:TMUBMUSD05Y), the yield is 4.32%, while 10-year notes BX:TMUBMUSD10Y yield 4.29%.

Covered-call strategies can help you generate much higher yields, but you will need to dig into the details to make informed decisions.

Covered-call definitions and an example from a pro

Ken Roberts, an investment adviser with Four Star Wealth Management in Reno, Nev., helps many of his clients enhance their income with active strategies, through which he writes covered call options for them. These strategies can be particularly effective when used for stocks that already have attractive dividend yields, he said during an interview with MarketWatch.

Not every investment adviser will be equipped to provide this level of service, or even be willing to do so. And an individual investor may not wish to pursue such an active strategy on their own. But Roberts said that "the extra few percent you get from writing covered calls can more than cover the typical 1% advisory fee."

Let's begin with a few terms:

A stock option gives an investor the right (but not the obligation) to buy or sell a security at a specific price (called the strike price) within a set time frame.A call option allows an investor to buy a security at the strike price until the option expires. A put option is the opposite, allowing the purchaser to sell a security at a specified price until the option expires.A covered call option is a call option an investor writes when they already own a security.

The idea of a covered-call strategy is to write (or sell) an option for another investor to buy a stock from you that you already hold, at a price that is higher than the current price. That is, a price at which you would be willing to sell the shares. The investor on the other end of this trade is hoping to profit if the share price rises higher than the strike price before the option expires. If that happens, you will be forced to sell your shares. But you will keep the option premium you were paid. And if the option expires without being exercised, you are free to write another option to collect more income.

Roberts provided this example on Friday. Keep in mind that share prices and option prices are always changing. This is a snapshot of what was available that day, and it is only an example. But it illustrates the concept.

Friday morning, shares of Chevron Corp. CVX were trading for $152.75. Roberts saw that there were call options expiring Sept. 20 with a strike price of $160, which an investor could sell for $3.50 a share. Chevron's dividend yield at that time, based on that price, was 4.27%, based on the company's quarterly payout of $1.63. One dividend payment will be made before the option expires.

"So if you were to get the dividend and be called out at expiration, you would have a gain of $12.38, which is a gain of 8.1% in 99 days," Roberts said. Breaking that down, if the option were exercised you would sell the stock for $160 a share, for a gain of $7.25 a share. To that you would add the option premium of $3.50 that you would have already received and the $1.63 dividend you would have received before you were called out.

Then your problem would be to find another stock to buy with the cash.

Of course, if the price weren't to rise enough for the option to be exercised before Sept. 20, it would be time to write another option - unless you were no longer willing to part with your Chevron shares.

When asked if the option premium in the Chevron example was so high because the strike price was only 5% higher than the stock price at that moment on Friday, Roberts said yes, while adding the reminder of how attractive the trade might be when including all of its elements described above.

But what if a 5% increase in the share price wasn't enough? What if the investor was only willing to part with the Chevron stock if it were 10% higher than that $152.75 price early Friday? That would be a strike price of $168.

Roberts said that at that moment $170 calls were available to sell for a premium of $1.18. So with that strike price and all other elements the same, with the investor called out at expiration, the gain would be $20.06 or 13.1% in 99 days. That would include the profit of $17.25 a share, plus the $1.18 premium plus the $1.63 dividend.

These Chevron examples show how a repeat process can be used to enhance income, which provides some downside protection to an investor. There is no downside risk. But there is upside risk. If Chevron's share price were to double before the Sept. 20 option expiration, the investor selling the covered call options would give up most of the upside.

Read: How Nvidia's new Street-high stock-price target stacks up in the chip sector

Grow an income stream: Why income hunters should go for dividend compounders over high-yielding stocks

Who might make best use of a covered-call option strategy?

"One thing I have run into, with people who do not like covered calls, is the tax consequences. They are OK of course in a retirement account," Roberts said.

There are many factors to consider. If you have stock investments in a retirement account, what is your investment horizon? If you have decades to go until you expect to stop working, a covered-call strategy might not be appropriate. It might be best to go for a growth strategy in the stock market, especially if you are making regular contributions to the account with a partial match from your employer.

But if you are looking to take a more conservative approach, with downside protection from the income, the covered call strategy might be appropriate in your retirement account. Then your tax consequences will be limited by how much income you have distributed from the retirement account.

For money in a nonretirement account, consider that a covered-call strategy will increase your taxable income and can lead to capital gains, which are also taxable. So your decision to write covered calls on individual stocks will need to factor in the price you paid for the shares. There are other factors, of course, including your federal tax bracket and your state income tax burden.

Using covered-call funds to avoid taxable events

Roberts mentioned some exchange-traded funds that make use of covered-call strategies that he has recommended for clients "who do not like the tax consequences" of the strategy when used for individual stocks. These funds can give you some capital growth over the long term, but the main objective is monthly income. The income is taxable for nonretirement accounts, but the stream of income will be more predictable because you will not be actively buying and selling options and stocks:

The J.P. Morgan Nasdaq Equity Premium Income ETF JEPQ holds most of the stocks in the Nasdaq-100 Index NDX which is made up of the 100 largest non-financial companies in the Nasdaq Composite Index COMP. The fund's stated objective is "to deliver a significant portion of the returns associated with the Nasdaq-100 Index with less volatility." That is a reminder that you give up some upside with a covered-call strategy. The fund follows the strategy by investing in equity-linked notes. The fund quoted a 30-day SEC yield of 10.30% as of May 31, with a distribution yield (based on the previous 12 monthly dividend payments) of 9.64%.The JPMorgan Equity Premium Income ETF JEPI follows a similar strategy as JEPQ, but it holds between 100 and 120 stocks selected for quality, while pursuing the covered-call strategy with equity-linked notes. This fund quoted a 30-day yield of 7.55% as of May 31, with a "12-month rolling dividend yield" of 7.58%. During times of high volatility, such as investors saw in 2022, call-option premiums will be significantly higher, so this type of fund can have a much higher dividend yield. That was the case when MarketWatch profiled JEPI in early 2023.For diversification away from large-cap stocks, Roberts has placed some client money in the Global X Russell 2000 Covered Call ETF RYLD. This fund holds nearly 1,900 stocks and writes covered-call options on the Russell 2000 Index RUT.

Don't miss: Dividend stocks can help lower your risk. Many are bargains right now.

-Philip van Doorn

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06-18-24 1002ET

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