The Fiscal Cliff is upon us.
And if you are a dividend investor, be prepared to give some of your hard-earned dollars back to Uncle Sam.
Exactly how many dollars? That depends on your income, of course. Last week I gave readers a “fiscal cliff” calculator to answer that question. And now, with an amount in hand, we can all figure out how much we need to make to get back some of our losses.
Let’s get to it.
For simplicity’s sake, let’s use the average stated in the link above. A married couple filing jointly with three exemptions and a $125,000 income would face $6,135 more in taxes, or a 28% increase.
Okay, $6,135 … that’s higher than I anticipated, which could be a challenge to make up annually.
Let’s see how much we can take off the $6,135 bill with this one simple strategy.
The strategy? Covered calls, a strategy I believe all self-directed investors need to take a serious look at going forward.
The covered call strategy is a conservative options strategy whereby an investor holds a long position in an asset and sells call options on that same asset in an attempt to generate increased income. Unlike buying options outright, this strategy allows you to take a conservative stance so you can sleep well at night.
All you need to initiate the strategy is 100 shares of stock and a highly liquid options market. By highly liquid, I mean heavily traded options that that have narrow bid-ask spreads.
If you own at least 100 shares of stock, then you have the ability to “sell a call” against your stock (assuming it has options, which most do). Remember, 100 shares of stock = 1 option contract.
Let’s say that you’ve worked hard to collect 500 shares of Wal-Mart (NYSE: WMT). Furthermore, you believe in the long-term prospects of the company and have no intention of selling the stock any time soon – it’s a long-term investment.
Given this scenario, how do you make back the $6,135 that Uncle Sam plans to take next year?
With Wal-Mart trading at approximately $72, the 500 shares are worth $36,000. Again, you like the stock’s long-term prospects but feel in the shorter term that it will likely trade relatively flat to lower, perhaps within a few dollars of its current price of $72.
If you sell a call option on WMT at the $75 strike in March (expires on March 15, 2013) you could bring in $105 per contract or $525 for your 500 shares. Do this four times per year and you could bring in $2,100. Not a bad way to tack on an additional 5.8% annually.
By comparison, if you went out to the $80 strike you could bring in $45 per contract or $225. Four times a year totals $900, adding 2.5% annually to your holding.
If you use this strategy, one of three scenarios will play out:
a) WMT shares trade flat (below the strike price) – the option will expire worthless and you keep the premium collected when you sold the calls. In this case, by using the covered call strategy you have successfully outperformed the stock.
b) WMT shares fall – the option expires worthless, you keep the premium, and again you outperform the stock.
c) WMT shares rise above your strike price – the option is exercised, and your upside is capped at your strike price plus the option premium collected. For example, if you collected $45 per contract, the covered call strategy will underperform the stock at any price above $75.45.
Remember, covered calls make money when stocks are slightly higher, flat or down. You only get the underlying stock "called" away if it rises significantly.
So again, why would any investor choose to shy away from such a proven income strategy that has outperformed the market and dividend-paying stocks over the long term?
And while we were not able to make back all of the $6,135, we certainly were able to make back a nice portion in a very conservative manner.
If you would like to learn more about how I use options for income or to steadily grow my investment account please be sure to sign-up for my free weekly report, The Strike Price.
Moreover, whether it’s Small Cap Pro editor Tyler Laundon and his impressive returns, or Jason Cimpl, editor of Top Stock Insights, with his above average gains we here at Wyatt Investment Research are here to give you actionable and sound ideas that you can use for your long- or short-term investment endeavors.
Editor and Chief Options Strategist