Tuesday, November 16, 2010

Covered Calls for more cash!

Dividend Machine, Microchip Technology has been a good company to create a little extra income in addition to its ever increasing dividend. 

Using covered calls to add income from your investments is one of the techniques, TheMoneyMadam, and all good income investors employ. 

To remind you about covered calls; when you own at least 100 shares of a company you can sell to another person the option to buy your shares at a set price (the strike price) within a set period of time. 

The other person obviously thinks the stock is going to increase in value and they are willing to pay you money to reserve the right to buy it at the strike price which almost certainly is below where they think the stock price will be in the future. 

This is a call option. The option gives the buyer the right but not the obligation. Therefore, if the stock does not perform as well as the buyer expected, they do not have to buy it from you and you pocket the cash from their buying the option. You risk being stuck with the company until the option expires if its stock price goes down. 

This risk is why I always recommend you buy stocks with dividend yields that are solid, and balance sheets that are solid. If you are stuck with the stock you liked it in the beginning and unless some huge fundamental factor has changed, you can sit with it cashing your dividends. 

Companies that have stock prices that move more than the over market can be identified by looking at their beta. Beta is a measure of price volatility. 

Microchip technology has a beta of about 1.13. A beta of 1 means the stock price moves just about in line with the overall market. A beta of 1.13 means MCHP is a little more volatile than the overall market. 

This situation provides the opportunity for selling covered calls. 

If you sell the right to buy MCHP to another person at a strike price at 10% above your cost basis and they exercise the right within 90 days you get the 10% gain, the cash from the covered call and probably the cash from the dividend. 

Another stock is always out there to buy, so do not be afraid to risk losing your stock at a 10% gain. Plus, with some volatility, you may have a chance to buy your stock again and repeat the whole procedure over and over. 

MCHP is a good example of this technique because I held this stock through the major downturn of 2008. I bought MCHP in October, 2007 at $36.50. I sold a call one year later at a strike price of $40.00 and received $1.60 per share for the call plus I had collected the dividend during that year. The market crashed, the call expired and I was stuck with the stock, but it is a stock I liked so I added to my position. I bought more at $31.87. 

I then wrote a call on those shares with a strike price of $35 and received $1.45 per share. I still held the stock because the market continued to deteriorate. When the market hit its low I added even more shares at $20.75. 

I continued to like the company and they continued to increase the dividend and I continued to cash that dividend. Finally I wrote a call for $1.05 with a strike price of $22.50. The market recovered and I lost the shares I bought for $20.75 at $22.50. I still own the other shares. 

I have not seen calls recently that I want to sell on MCHP but this exercise clearly illustrates how you can get 10% per year or more using covered calls on dividend producing stocks to create income.

Very Truly Yours,

Another Dividend Machine idea next week