Tuesday, March 8, 2011

We need market volatility

Income investors need market volatility even though it scares the begeezes out of them. You see, volatility provides a chance to buy cheap and sell expensive and it drives covered call income.

Covered calls are one of the legs of our 3 legged income stool. Dividends, bond interest, and covered call income are key pieces of the income investor's cash flow strategy. Volatility drives covered call income. When another person thinks a stock is going to have a big gain they will buy a call from you for the privilege of paying you only the strike price of the covered call. We do not care what they do with the stock once they buy it but we do care about having to keep the stock because the price did not go up beyond the strike price so the call buyer allowed their option to expire. This is why we only own solid companies that pay dividends. We need those solid companies that pay dividends to have significant price fluctuations. We are not nervous when things are cheap because we can always bank the dividend and wait for a turnaround. We are not nervous when prices get expensive because that is when we sell a call on our solid, income producing company.

Remember, you have to be willing to take profit. Buy and hold works if you have a company that increases the dividend every year through thick and thin. Buy and hold works when in addition to increasing the dividend every year the stock price continues to increase with the general trend of the market. But to enhance your income, you have to be willing to sell a covered call on those stocks you own with at least a 10 percent gain.

Let's use an example. Chevron has been in and out of my portfolio many, many times and the reason is CVX is volatile. I do not try to time the market. Instead I use a disciplined approach. When I buy it, I have to have at least a dividend yield close to a 5 year treasury. Today we mark that as a dividend of greater than 3%. Several weeks ago I profiled CVX as a dividend machine provided you paid less than $96 per share. At the time, I paid $93.37 per share. This week I will get a dividend of $.72 per share. Today I wrote a call for June, 2011 with a strike price of $115 for $1.10. Since I will probably hold the stock until June, I should get a second dividend of $.72 in June. (Note that the buyer of the option could buy my stock before June. They have the right but not the obligation to buy it.)

Here is the math: Cost basis = $93.37. Income includes two dividends of $.72 each, call premium of $1.10 and capital gain of $21.63 if they take my CVX at $115 for a total income of $24.17 per share in less than 4 months. This is a total return of 25.89 percent. Perhaps CVX will go to $150 and maybe that will happened but we cannot be greedy. Take your 25+ percent and look for another solid, dividend producing company on which you can work this same magic.

We have not had enough volatility this quarter for my taste. I like the dividend machines but the covered call angle makes retirement income much easier.

Very Truly Yours,