This is a rather simple strategy with which I am sure a lot of seasoned traders are very familiar, possibly under some other name with which I am not familiar. I wanted to write about it because I don’t see anyone talking about it anymore. Since
big hey-days of day trading and, of course, burst of Internet bubble of 2000, there seems to be a lack of patience that this strategy needs to work. A lot of people seem to be moving back into markets since declines of 2000. If you were one of those that jumped back in during early part of 2004 you reaped big profits. But now there seems to be a fair number of Wall Street Pundits that are beginning to raise "irrational exuberance" flag once again. If you have been watching some of unrealistic gains in recent high flyers, you may be looking for a bit more conservative way of being in market.
In early 70’s I met a young Dean Witter Reynolds broker and told him I had a few dollars I wanted to put into stock market. The first thing he told me was that unless I had $100,000 I wanted to invest one time into a diversified portfolio with a buy and hold strategy…or…. $10,000 I wanted to invest in a more aggressive "trading" strategy, he was not interested in my account. Keep in mind, this was a long time before day trading craze hit. I was impressed with his straightforward and honest approach. However, I did not have $100,000 back then, but I did have a bit more then $10,000. With that we were off to races, and this is trading plan he put to work for me.
First of all he stayed away form high flyers altogether. He followed a number of solid, top quality companies that had a history of paying above average dividends but still with a little bit of volatility. Both dividend and volatility are required ingredients.
We bought six to ten positions with an average of 300-500 shares in each position. Every stock we bought paid higher then average dividend. We did well with companies like Phillip Morris [MO], American Electric and Power [AEP], Battle Mountain Gold Co. [now a pink sheeter], General Motors [GM] and few others. I only mention them so you that are nuts-o for research (exactly sort of thing I would do) can go back and see sort of movement we had in these stocks back in those days. There were others of course, but that will give you some fodder for research. GM and MO may still work these days, but I have not looked at AEP in years and, of course, Battle Mountain is history.
Okay, so now you know what sort of companies we are looking for; solid, higher then average dividend paying companies with a bit of volatility. Hey, I never said this was easy! But to make it even more challenging, we need one more component to make triple dip into money - Options. To be more specific, we need Covered Calls only!!! Let me repeat that, we are only selling covered calls, no other options. You will have to be cleared by your broker for options trading, and you will need a margin account. Here’s how play is made. You buy 300-500 shares of a stock that is going to be paying a dividend with in next 15-45 days. You sell 30-60 day covered call taking in premium money and giving you that amount of money downside protection to offset any move against you.
The ideal trade will play out like this. You will buy stock, it will pay dividend while you own it, you sell Covered Call collecting options premium money, and hopefully stock will be called away at strike price. Obviously, you have to make sure you only sell call with a strike price higher then your entry price. Now let’s apply math on a hypothetical trade. Let’s say you buy MO at $50 and it is paying $.25 dividend and $51 call option is selling for $.25 with an expiration date 45 days out. Let’s further assume stock pays dividend, and moves above strike price of $51 by expiration date and it gets called away. You will earn $.25 for dividend, $.25 for premium money on call and $1.00 on stock position itself for a total gain of $1.50 on 300 shares. That’s $300 on a $7500 investment (using 2:1 margin account) for a 24% annualized yield on your money. More of math: $300 divided by $7500 = 4% X 8 = 24%. Keep in mind you made $300 in 45 days meaning theoretically you can do this 8 times a year. That’s how you get 24% annualized yield. Not to shabby! (Because commissions vary, I have not put them into equation, something you will have to do obviously.)
