Income Investors Who Focus On Growth

Are you an investor who needs current income but who also needs your portfolio to grow in value? Income investors who focus on growth typically invest in stocks that offer a high dividend yield and that are also expected to appreciate in price. A solid, time-tested strategy. But, there is a way that you can increase the income your portfolio generates without sacrificing any growth potential. If you write (sell) out-of-the-money covered calls on the stocks that you hold, your income will be increased by the option premiums you receive for writing these options. A call option gives the buyer of your option the right to purchase the stock from you at a pre-determined price within a given period of time. An out-of-the-money call means that the pre-determined price (the strike price) is higher than the current market price of the stock. So, the call buyer will not choose to exercise his option—i.e., force you to sell your stock to him—as long as the market price of the stock remains below the strike price. But, you say, you're investing for growth, too, so you are expecting the market price of your stock to increase, and you want to keep the shares that you own. Not a problem. You can execute what is called a closing purchase transaction to reverse out of your position as writer. Essentially, this means that you enter an order to purchase an identical call. As long as you do so before the strike price of the option is reached, you will likely be buying the identical call for a price that is lower than what you received when you sold (wrote) the original option, so you will still enjoy a net gain in income. To explain how this works, let's dig a little deeper into what affects the value of an option (i.e., the option premium.) The value of an option is the sum of its intrinsic value and its time value. The intrinsic value of a call option is equal to the greater of the difference between the market price of the stock and the strike price of the option, or zero. This means that if the difference between the market price of the stock and the strike price of the option is a negative number, its intrinsic value is zero. The option has value only because it has time left to expiration. This is the case with an out-of-the-money call option. Its only value is its time value. And the less time there is to expiration, the lower its time value. Consider, for example, Hasbro, a company that has both a relatively high dividend yield and good growth potential. The company currently pays an annual dividend of $1.00 a share, and its dividend yield is 2.1%. Based on its financials, its sustainable growth rate is a healthy 19.4%. Its stock price on October 18, 2010, is hovering around $47.00 a share. On this same date, a call option on the stock that has a strike price of $50 and expires on January 21, 2011 is selling for $1.25. Since the strike price is greater than the current market price, the intrinsic value of the option is zero. The reason that the option is selling for a positive price--$1.25—is because Hasbro's stock price may increase to $50 and beyond by January 21, 2011, making the option more valuable. A standard option contract is for 100 shares, so if you own shares of Hasbro and write (sell) this covered call, you will receive $125. If Hasbro's stock price never increases to $50 a share prior to January 21, 2011, you have $125 more in income than you otherwise would have. But, let's suppose that Hasbro's stock price is slowly increasing and that by, say, the middle of December 2010, it is selling for $49.00 a share—which is a significant percentage increase of 4.26%% for the two-month time frame. Annualized, this translates to a 28.4% increase in price in a 12-month period. If you think this trend is likely to continue, maybe you want to hold onto your shares. You, therefore, "buy to close," which means that you enter an order to buy a standard option contract with a $50 strike price that expires on January 21, 2011. How much will you have to pay for it? All else equal, you can expect to pay less than the $125 you received for writing the option. Although Hasbro's market price has increased, it is still below the option's strike price, so the intrinsic value of the option is still zero, and there is now only about a month left on the contract, so the time value of the contract has decreased. Thus, by writing a covered call, you have increased your income on an investment in 100 shares of Hasbro's stock from the $100 that you expect in dividends to some higher amount. If Hasbro's stock never increases to $50 by January 21, 2011, that higher amount is $100 + $125 = $225. And the good news is that you can continue writing covered calls and collecting premiums for as long as your own the stock, adding even more cash to your account. Something to consider.