Since early 2014, I’ve been telling you about my favorite way to generate safe, high income in the stock market.[hana-code-insert name=’adsense-article’ /]If you’re not familiar with this strategy, it simply involves selling either a covered call or a cash-secured put on a reasonably-priced, high-quality dividend growth stock.
I’ve often referred to this type of trade as a “10% Trade” because it’s designed to generate 10%-plus annualized yields.
Going forward, however, I’ll simply refer to these as “high-yield” trades.
That’s because from time-to-time I think there are compelling opportunities to make one of these trades even when it targets less than a 10% annualized yield.
Consider the high-yield trade I just made with Starbucks (SBUX), our Undervalued Dividend Growth Stock of the Week…
Opportunity to Capture an 8.1% to 22.6% Annualized Yield from SBUX
Yesterday I bought 100 shares of SBUX for $53.42 per share and simultaneously “sold to open” one October 20 2017, $55.00 call for $0.91 per share.
By selling the call option, I’m giving the buyer of the option the right, but not the obligation, to purchase my 100 shares at $55.00 per share (the “strike” price) anytime before October 20 (the contract “expiration” date).
In exchange for that opportunity, the buyer of the option paid me $0.91 per share (the “premium”).
Because I collected immediate income when the trade opened, I’m lowering my cost basis on the shares I’m buying.
This is precisely what makes this kind of trade safer than simply purchasing shares of the underlying stock the “traditional” way.
Yes, I’m limiting my potential upside (if SBUX shares climb to $65, for example, I’ll still be forced to sell at “just” $55)… but that would still generate a capital gain for me… AND I’m generating immediate income in the process.
It’s a trade-off… and one I’m willing to make because this strategy, by its very nature (selling a call option instead of buying one), is designed to be conservative and to generate income.
With all of this in mind, there are likely two ways this trade will work out — and they both spell high annualized yields on my purchase price…
Please note: To be conservative, I don’t include any dividends in my calculations for either of the following scenarios. Any dividends collected are just “bonus” that will boost the overall annualized yields even further.
Scenario #1: SBUX stays under $55.00 by October 20
If SBUX stays under $55.00 by October 20, I’ll get to keep my 100 shares.
In the process I’ll also have received $91 in call income ($0.91 x 100 shares).
The call income — known as a “premium” in the options world — was collected instantly yesterday. It was deposited in the account where I made the trade, which is my 401(k) retirement account.
At the end of the day, if “Scenario 1” plays out I’ll be looking at $85.35 in profit after commissions and fees.
On a percentage basis, I received a 1.7% yield for selling the call ($0.91 / $53.42).
When I subtract out the commissions and fees I’m looking at a 1.6% yield in 72 days, which works out to an 8.1% annualized yield.
Scenario #2: SBUX climbs over $55.00 by October 20
If SBUX climbs over $55.00 by October 20, my 100 shares will get sold (“called away”) at $55.00 per share.
Like “Scenario 1”, I get to keep the $91 in call income ($0.91 x 100 shares). But I’ll also generate $158 in capital gains ($1.58 x 100) since I bought at $53.42 and will be selling at $55.00.
In this scenario, after commissions and fees I’ll be looking at a $238.40 profit.
From a percentage standpoint, this high-yield trade will deliver an instant 1.7% yield for selling the call ($0.91 / $53.42) and a 3.0% gain ($1.58 / $53.42).
After subtracting out the commissions and fees, I’m looking at a 4.5% total return in 72 days.
That works out to a 22.6% annualized yield from SBUX. Not bad, considering the stock’s “regular” yield is just 1.9%.
P.S. I only made this trade because: 1) I want to own the underlying stock anyways 2) I believe it was trading at a reasonable price when I made the trade 3) I am comfortable owning it for the long-haul in case the price drops significantly below my cost basis by expiration and 4) I am comfortable letting it go if shares get called away. To be mindful of position sizing, except in rare cases, the value of this trade wouldn’t exceed 5% of my total portfolio value. In addition, to minimize taxes and tax paperwork, I made this trade in a retirement account.
P.P.S. I realize the typical financial advisor may think it’s crazy to trade individual stocks in a retirement account… no matter how safe a stock may appear. And in many cases they’re probably right — especially if you’re not properly diversified and you’re heavily dependent on the income from this account. So I urge you not to blindly follow my lead today without first speaking to a professional advisor or doing your own due diligence and research. In addition, I’m not a tax advisor and I don’t claim to be… so please consult a professional for any tax related questions you have.[hana-code-insert name=’MMPress’ /]