Boost Your Dividend Income With Covered Calls: The Step-By-Step Guide

That’s a good question and I’m glad you asked. Options can get complicated, so let’s keep it simple.

A call option gives the buyer the right, but not the obligation, to purchase 100 shares of a security at some later date in the future. So if you hold a call option on say The Coca-Cola Co (NYSE:KO) with a $50 strike price and an expiration date in June, this means you can buy 100 shares of Coca-Cola for $5,000 anytime between now and the expiration date in June.

If the share price is above $50 this would be a good deal. By exercising the option, the call owner could buy something for $50 that might be trading hands at $52 or $55 in the open market. In this case the call option is said to be “in the money”.

Alternatively, if the share price is below $50 it’s “out of the money”. In this case there would be no incentive to exercise the option. Instead of buying shares at $50 the call owner could simply buy shares for a lower price in the open market.

The call seller is on the opposite end of the transaction. Instead of having the right to buy at a certain price, you have the obligation to sell 100 shares at that agreed upon price. So using the same example, if shares of The Coca-Cola Co (NYSE:KO) are trading above $50, you’re “stuck” selling at $50 regardless of what is available in the open market. Alternatively, if the price is below $50, the option is likely to expire unexercised and you do not have to sell your shares.

The reason that it is called a “covered” call option is because you own the underlying security. You can sell call options without owning the security, but we’re keeping it simple in this example. We’re only thinking about possibly using covered calls.

So why would anyone make such an agreement? You’re asking a lot of good questions today. The option seller receives a premium (read: upfront cash) for making this agreement. Should the option expire worthless, you keep the premium (Actually even if the option is exercised, you still keep the premium).

An Example of Covered Calls

Coca-Cola is always a dividend crowd favorite, but let’s select another security to make the demonstration clear. Let’s say that you own 100 shares of Target Corporation (NYSE:TGT).

Source: Target Investor Relations

We’ll take a “bullseye view” for investors. Target is one those funky, cool stores that works to set itself apart. It still sells many of the same items as Wal-Mart Stores, Inc. (NYSE:WMT), but it goes about it a fresher and cleaner way. I had a friend that called it the “$100 Store,” because everyone time they went in they ended up walking out with $100 worth of stuff.

The business history of the company has been quite solid. Over the past decade earnings-per-share have increased by about 6% annually. This was driven by a robust share repurchase program (with an average reduction of over 3% annually) to go along with reasonable revenue growth and a steady profit margin.

The dividend has been even more impressive – moving from around $0.40 back in 2005 to today’s mark of $2.24 (of course the payout ratio has subsequently increases as well). Just recently the company announced its 195^th consecutive quarterly dividend payment (dating back to 1967) and Target has not only paid but also increased its payout for 44 consecutive years. It’d be fair to suggest that the company has been reasonably shareholder friendly over the years. Target’s long streak of dividend increases makes the company a Dividend Aristocrat.

Based on a share price around $82, and forward guidance of adjusted earnings in the $5.20 to $5.40 range for 2016, shares are currently trading hands around 15 or 16 times expected earnings; which is more or less in line with the security’s historical average.

As such, you might be quite content holding shares, watching growth formulate over the years and collecting a reasonable and increasing dividend.

Then again, the “current” yield sits at just 2.75% – above your average S&P 500 (SPY) company but below many other dividend growth counterparts. Perhaps you’d like to receive more income.

In making this judgment, there’s no reason to fret. You can both own shares in the company and generate a higher cash flow stream.

And by the way, I’m just using Target Corporation (NYSE:TGT) as an illustration, naturally any number of securities work for this exercise.

Let’s See What Option Contracts Are Available

With options you have literally thousands of possibilities: different expirations, strike prices, combinations, you name it. But remember, we’re keeping it simple.

Any basic brokerage account will have information on options, but not everyone uses the same one. As such, using basic public information can be a helpful reference point.