Investing is about getting the highest return for the lowest risk. Buying high yielding blue chip dividend stocks is one method of generating an income in the stock market.
Recently though, this type of investing has come under attack. Since the 2008 stock market crash, publicly traded shares have experienced volatile price movements. Investing in blue chips for dividends could result in a large capital losses that is hardly offset by the meager annual payouts. A method to increase dividends and lower capital risk can be used to counter this.
Highest Yielding Dividend Blue Chip Stock Strategy
With this strategy there is two goals:
- Maximize dividend payout
- Lessen the risk and impact of a down market
One can achieve this goal by selling deep in the money covered calls. How does this strategy work?
Dividend Test Case: Garmin Limited
- In the summer of 2010 the price of GRMN is $30.36 per share
- The trailing dividend paid out amounted to $2.25 per share or a yield of 7.4% of the share price
- The forward annual dividend is $1.5 per share or 5% per year
Garmin is a high yielding dividend paying blue chip stock, but it also has experienced some large and volatile swings. If the stock market were to dive again, how could capital losses be protected against? Selling deep in-the-money call options will help. First, how does this strategy maximize dividend payouts?
Increasing Investing Dividends with Options
Many investors simply purchase blue chip stocks and wait for the annual dividends. $10,000 of capital will translate into 329 shares of GRMN at today's prices.
Buying the stock and selling bullish call options on the stock will provide immediate income and lower the cost of ownership. When buying blue chip shares this translates into a larger volume of shares for the same amount of money. The investor who buys shares and sells call options retains full dividend rights.
The investor in this example will buy shares of GRMN and sell long term call options that will expire in 17 months. The call options will have a $25 strike price. The revenue generated is $7.75 per share.
- Buy GRMN at $30.26
- Sell $25 strike price call options for $7.75 per share
- Investor cost per share is $22.51
What does this mean? First, the investor is able to buy 35% more shares. With $10,000 the person now has dividend paying ownership on 444 shares. Another way to view this is that the dividend just went up 35%. The annual dividend of 5% now has an effective value of 6.6% annual dividend yield. The blue chip trader will receive $666 dollars in dividends instead of only $500.
Each stock an investor tries this strategy with will have different payout ratios. Still, if long term options are available on the stock, an investor can be sell in the money covered calls for increased shares and higher dividend payouts.
Covered Call Option Strategy for Reduced Market Risk
This dividend strategy also reduces the risk of a falling market. Since call options with a strike price of $25 were sold, the share price can fall down to this level without hurting the investment capital. The idea is similar to owning the first mortgage on a home. The second and third mortgages will lose out in a down housing trend while the first mortgage will continue to be protected. The owner of the blue chip shares essentially sold of a second mortgage on his stock that will take much of the market loss.
GRMN can fall from $30.26 down to $22.51 per share, or by 25%, and all of the investment capital is still preserved. Stock prices can fall over 17%, or down to $25 per share and capital investment will still appreciate by 11% in 17 months. The 11% is the difference between the $22.51 cost and the $25 return.
If share prices rise, stay the same, or fall up to 17%, the total profit gained in one year will be 7.7% from option income (11% over 17 months divided into 12 months) along with effective 6.6% dividend gains (based on money invested and not shares) equaling 14.3% profit in one year. This is true even if prices fall by the aforementioned amounts.
Risks and Warnings with High Yield Dividend Strategy
Option contracts can be exercised at any time. What if the options contract is exercised right away on the blue chip dividend stock? The cost of ownership per share is $22.51. The investor holding the shares has rights on the first $25 on the share price. Options can be exercised early but this will equate into an 11% gain. Options can only be exercised when stock is above strike price.
Selling covered calls means that the shareholder must retain the shares until expiration date or buy back the options when selling shares early.
The call options written and sold will devalue by amount of the dividend around the same time the stipend is being recorded and paid out. This will lower the buffer protecting the investor from capital loss but it will also create a more profitable exit opportunity if the investor wants to buy back the options and sell the stock early.
Maximizing profits with a high yielding dividend strategy on blue chip stocks is one method to earn money in volatile markets.
References
Nathan Mosakowski, "Covered Writing: Three Ways to Play Earnings," 01 Feb 2006, Forbes.com
Jeff Neal, "Outside the Box: Understanding the Covered Call Strategy," 28 Jan 2009, Forbes.com
Richard Loth, “Investment Valuation Ratios: Dividend Yield,” article accessed 09 August 2010, Investopedia.com
