A few days ago, I shared a simple investment strategy you could use to create a growing income stream over your lifetime.
Yield on cost simply looks at your current dividend payment on a stock today, divided by your original purchase price.
If you buy the right kind of dividend payers, your yield will rise over time when measured against what you originally paid for the stock.
In some instances, your yield on cost will rise well into the double-digits.
I used this strategy during the Great Recession to scoop up big names like McDonald’s (MCD) and the Walt Disney Company (DIS) at a discount.
I bought those names for $55 and $19, respectively, in 2009… and I’ve seen returns of 530% and 507% in the time since.
Today, McDonald’s has a 2.2% dividend yield. By comparison, the average yield on the S&P 500 is 1.7%. That means MCD pays about 30% more than the average S&P 500 stock.
But that 2.2% yield is only one-half of the story. Today, McDonald’s annual payout is $5.52 per share.
So my “yield on (original) cost” is just over 10%. That’s not a typo. I’m making 10% per year on my McDonald’s stock.
But sometimes, even the most reliable dividend-payers do something unexpected… and after years of increased dividends, the payments stop.
That happened to me with Disney, which paused its dividend in 2020.
For many dividend investors, a dividend cut means only one thing: Hit the sell button!
But I’m still earning steady streams of income from my Disney shares. How? I’ll show you how below…
How to Create Your Own “Dividend” Using Options
The way I earn a “dividend” on my Disney shares is through options – specifically “covered” call options.
When most investors hear the word “options,” they probably imagine high-risk, complicated trades.
But selling covered calls on reliable blue-chips you already own isn’t as risky or difficult as you might think.
Covered calls are options you sell on stocks you already own. As long as you limit your sale to 1 contract for every 100 shares you own, you’re covered.
The alternative, selling uncovered calls, sounds great in practice… but it could blow up your portfolio if the underlying stock rallies significantly.
You’d been on the hook to purchase 100 shares per contract at the strike price… and deliver them to the buyer of the contract. Plus, you wouldn’t pocket any of the price appreciation.
We want to use options to lower our portfolio risk… not raise it.
With covered calls, you’re trading some potential upside in the shares for immediate income.
Here’s how it works…
First, you pick a target price (called a “strike”) you think the stock is unlikely to hit before the option expires.
The strike price should be 10–25% higher than the stock’s current price if you want to keep your shares.
Then you pick an expiration date about 2–3 months out…
Options will lose value over time as they get closer to expiration – like the “best before” date on a milk carton. I’ve found that 2–3 months is when time decay is the steepest.
After you’ve chosen a strike price and expiration date, you sell the matching call option for an upfront cash payout (called a “premium”).
Again, as long as you own at least 100 shares for every call option you sell, your trade is “covered.” The 2–3-month period means you can execute this trade (and collect upfront payments) 4–6 times in a year.
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 already 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’s buyer for the strike price.
Now, there are some risks to selling covered calls.
If the stock gets called away, you’ll miss any significant price appreciation it sees above the strike price. There’s also a chance your stock gets called away at a lower price than your initial purchase price, resulting in a potential loss.
If you love the stock you own, make sure to set the strike price far enough away from the share price to reduce the chance of your underlying stock getting called away.
The premium (income) will be a bit lower, but the chances of you having your shares called away will be, too.
Charging “Rent” on Your Shares
In early 2020, Disney suspended its dividend. And it hasn’t been reinstated since.
But instead of selling my shares, I created my own “dividend” on the stock… and I’m still collecting those payments two years later.
Let me give you an example…
Right now, I could sell the October 2022 $135 calls on DIS for $2.40 per share. DIS currently trades around $120. So my strike price is 12.5% away from the share price.
Multibillion-dollar blue-chip companies like Disney don’t often see 10% rallies in two months. So I feel confident DIS likely won’t hit the strike price.
Each options contract covers 100 shares. So I’d make $240 per contract. That’s a 1.9% return in just two months.
That may not seem like much. But remember, the average yield on the S&P 500 is 1.7% annually. So that’s a nice chunk of income from a low-risk trade that would last about 8 weeks.
And if I could make about $2.40 per share in extra “rent” payments from Disney every two months, that’s $14.40 per year. That’s an extra 11.8% return from the stock, on top of any price gains.
Let me be clear. Low-risk doesn’t mean no risk.
There’s a chance Disney continues to rocket higher. Disney just had a solid earnings report this week, and the market likes the company’s plan to raise prices on its streaming service.
If the share price goes above the strike price, my DIS shares would be called away. This means I’ll lose any gains above the strike price.
But I’ve been using this strategy routinely over the past two years to churn out income on my DIS shares… and they haven’t been called away yet.
Bottom line: If a stock stops paying a dividend… consider selling covered calls on your shares. It’s a strategy I’ve used to make back more than what I’ve spent on my Disney shares.
I like to think of it as “charging rent” on the holdings in my portfolio.
Good investing,
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Andrew Packer
Analyst, Palm Beach Daily
P.S. Covered calls are one of the best ways to yield income on stocks you already own…
And recently, Daily editor Teeka Tiwari identified an “Anomaly” in the market that can give you the opportunity to make crypto-like gains from those same blue-chips.
It’s a chance to capture 21 years of market gains in as little as 90 days… and this past month, Teeka’s used this strategy to book gains of 43.8%, 52.3%, and 77.8% in just two weeks.
To learn more about this “Anomaly,” and how you can still profit from it, click here.