|September 22, 2014
How To Earn A 9.2% Yield From A Stock Paying 5.9%
By Nathan Slaughter
October will be the three-year anniversary of the last market trough. And during this stretch, we haven't had a single correction (defined as a pullback of at least 10%) -- not one in the past 36 months.
But that could be changing... All bull markets are punctuated by the occasional pullback. It's not a matter of if, but when.
According to Forbes, there have been 16 bull markets since the Great Depression. In that 80-year span, only 3 of those lasted longer than five years -- all were so-called "super-bulls."
Our current bull market last experienced a correction in October 2011, but technically dates back to the rally beginning in March 2009. So this advance is currently at 5.5 years and counting.
The next pullback may not be coming next week or next month, but it will most definitely happen -- the market just needs an excuse.
And given all the geopolitical uncertainty in Israel, Iraq, the Ukraine and elsewhere, it will get one eventually. But given the strong macroeconomic backdrop, any correction will be more of a pause than an outright reversal.
So how to prepare?
I've already told my High-Yield Investing readers a few valuable steps to take. First, tighten up stop-losses (which automatically trigger a sale to help lock in gains) in case the market rolls over. Second, consider eliminating some of your more vulnerable positions. These may include high-beta stocks that are jumpy, cyclical stocks that are at the front-lines of a downturn, and recent winners with stretched valuations that may be prone to profit taking.
As an investor, I don't advocate gutting your portfolio if the market sours. But I do take note of the changing environment when putting any new money to work.
Nobody wants to recklessly deposit new hard-earned assets into the market just in front of a potential correction. But leaving your cash languishing in the bank or money market at 0.1% won't get you any closer to (or through) retirement either.
Is there a safe way to stay both invested and protected?
Yes, there is. It's a way to earn dependable income and participate in further market upside, without being fully exposed to the downside. It can also be used to effectively boost our income yield on stocks we own.
Let me show you an example, using a deep-water driller I hold in my High-Yield Investing portfolio -- Ensco (NYSE: ESV).
Let's say I buy 100 shares of ESV. It's trading just under $45 per share, and offers a dividend yield of 5.9%. I think the stock will move higher over time. But it could be a bumpy ride over the next few months.
One way to mitigate risk -- and generate extra income at the same time -- is by selling a covered call option on the stock.
Call options simply convey the right (but not the obligation) for one investor to purchase a stock from another investor at a pre-designated price. In this case, I'm looking at a December 20 call option on ESV with a strike price of $50.
This call option sells for a premium of approximately $0.51 per share. As the seller, that's how much cash I would receive upfront from the buyer. (With covered calls, you must own 100 shares of stock to sell one option contract, so I would receive $51 in premium income if I sold a contract on my 100 shares.)
Now, if ESV fails to rise from today's $45 share price to its $50 per share strike price by December 20, then the option will expire "worthless." That means we would keep our 100 shares of the stock and pocket the $0.51 per share premium as a bonus.
Earning $0.51 per share in premium income may not sound like much at first. But with shares trading around $45, that premium income would give us an income yield of 1.1% ($0.51/$45) in just four months. If we did three trades like this over a 12 month period, we'd earn a 3.3% yield from the premium income.
By itself, ESV already offers a sizeable 5.9% dividend yield. But utilizing this covered call strategy would add another 3.3% in premium income, boosting our income yield to 9.2%.
Here's another benefit to this strategy. In a falling market, the $1.53 per share we'd receive over 12 months in premium income would soften the blow, essentially meaning ESV could decline 3.3% to $43.47 from $45, and we would still break even from today.
But what happens if ESV rises above the $50 strike price? Per the option, we'd have to sell our 100 shares to the owner for $50 per share. But that's still a nice 10% gain from the $45 share price we bought the stock at -- and we'd still get to keep the premium income as a parting gift.
Bottom line, we could simply buy Ensco stock and be content with its 5.9% dividend yield, or we could use this covered call option strategy to boost our annual income yield to 9.2%, minimize downside risk and still get to keep our shares as long as it stays under $50. And even if the stock's price does rise over the $50 strike price, we get to lock in a 10% gain.
This near 'win-win' strategy offers a great way to boost your investment income and build in some downside protection for your portfolio at the same time. In fact, my colleague Amber Hestla uses this exact strategy to collect income payments of $1,047, $2,435, $3,410 (and sometimes more) from nearly any stock -- including ones you already own. You could think of this strategy as if you're "renting" out your shares of stock. To learn more about Amber's unique income strategy, visit this link.
Chief Investment Strategist