Boost Your Dividend Portfolio; Reinvesting Dividends, Selling Puts and Covered Calls, Capital Gains
Anyone with a basic understanding of investing can set up a dividend portfolio. It's a set it and forget it way to make money.
But with just a little more active management, you can supercharge your dividend portfolio in several ways. By:
reinvesting your dividends,
selling puts when you want to buy shares,
using the shares you own as collateral to sell covered calls and
occasionally taking profits/capital gains on part of your position,
you can significantly reduce your cost per share and increase your effective dividend yield. You can even sometimes bring your effective cost basis all the way down to zero and still have cash flowing into your account.
Read on to find out what dividends are, and learn ways to boost the income you receive from your dividend-based investments.
What are Dividends?
Not all investments pay a dividend, but the ones that do, pay shareholders a periodic portion of their profits for each share owned by the shareholder. These positions create passive income, and often the value of the shares will increase at the same time, further increasing the value of the position.
You may be wondering why some companies pay dividends and others do not. Companies do different things with their profits.
Some use profits to grow the business (open another store, create new products, build a factory, invest in research and development) or to pay down debt to strengthen the company financially.
And some companies, usually well-established, profitable ones, pay a portion of their profits to their shareholders with dividends.
Dividends are cash payments and are often paid quarterly, or about every three months.
Four Ways to Lower Your Investment Costs
I build my dividend positions in four ways to maximize my income, or yield.
I buy more shares (without paying additional funds out of pocket) with dividend reinvestment, or DRIP,
sell cash secured puts to add to my position at a reduced cost,
sell covered calls to make extra cash with shares I own, and
occasionally sell some of my shares to take profits and lock in some of the capital gains on my positions.
DRIP
If you own a dividend stock, you can take your dividends in cash, but many investors use a DRIP, or Dividend Reinvestment Plan, to set their dividends to automatically reinvest in the company that issues them. The dividend income is used to purchase more shares of the same stock.
If you reinvest dividends, you can exponentially boost your long-term returns because of the power of compounding. Your dividends buy more shares, which increases your next dividend, which lets you buy even more shares, and so on. The price of the shares you already own may be increasing during this time as well.
Are You Ready for Options?
Use this checklist to see if you have the knowledge, experience, and financial resources to safely incorporate options into your investing strategy. If you are ready, you can learn to sell cash secured puts and covered calls to improve your positions.
Sell Cash Secured Puts
If you have enough capital to buy 100 shares of a stock or ETF at one time, you can buy them at a reduced rate by selling cash secured puts to lower your investment entry costs.
Selling a put is like being paid to set up a limit order to buy 100 shares of stock. If you use a put option to buy stock, you can name your purchase price for the shares by choosing a strike price you like, just like you use a limit order to name the share price you are willing to pay when you buy stock outright. You just get paid a little extra cash when you set up the order.
As with any investment in the stock market, there are some risks with selling a put. But, the risks of selling a put can actually be less than the risks of buying the shares outright.
Sometimes you sell a put with a fair strike price, but at expiration, the stock is worth significantly less than the strike price. You buy the shares and pay the strike price anyway. You may regret that you did not wait to sell the put or choose a lower strike price. This is not unlike a situation where you buy shares of stock, and they decrease in value soon after you buy them. Stock prices are expected to fluctuate and it's impossible to time your purchases perfectly, with or without using a put.
And sometimes you sell a put, hoping to buy stock at a discount, but you are not assigned to buy the shares. If the price of the stock stays flat or rises, the put will expire worthless and the stock will not be assigned to you. If you were hoping to buy the shares, you may regret not buying the stock sooner or at a lower price. This is similar to considering, and deciding not to buy stock, then regretting your decision as you watch the share price rise.
Summary: Risks Selling a Put
If the share price stays flat or increases, you might miss out on buying stock you want.
If the share price drops more than you expect, you are still obligated to pay the price to which you committed.
But even if one of these things happens, you still have received payment up front for the put, and you get to keep that premium.
You can control the risk by
selecting high-quality underlying stocks you would be happy to own and
choosing strike prices you would be willing to pay for them.
So when you sell puts, you only risk buying 100 shares of stock at a price you have chosen. As long as you are buying high-quality stocks or ETFs, you might not worry too much about small fluctuations in the share price, especially if using the put reduces the cost for the shares you are buying.
Sell Covered Calls
Once you own at least 100 shares of a stock or ETF, you might consider selling a covered call as another way to generate extra income from them.
If you sell a call, you get paid money up front. You may then be required to sell 100 shares of your stock, at the strike price you selected, any time until the option expires.
There are some risks in selling a call, but if you cover the call with 100 shares of stock in your account, the risks are minimal. The risks are mostly about loss of opportunity or limiting your possible gains.
Risks in Selling a Call
You risk that the price of the stock you are holding might decrease in value. (But, that would have happened whether you sold the call or not.)
You risk limiting, or capping, your profits. The price of the stock may rise above your strike price before the expiration date. Since you are committed to the contract, you can’t take advantage of the price jump to sell the stock at a higher price.
At expiration, you may be assigned to sell your shares for less than the current open market price. The regret you may experience if the stock price rises above your strike price is similar to watching the price of a stock rise after you have sold it without the call contract.
You can control the risk by selecting a strike price that is higher than the amount you paid for the shares. You can make money one or two ways.
You will keep the premium you are paid up front for the call no matter what happens after.
You may be assigned to sell 100 shares of your stock for a profit, if the share price rises above your chosen strike price, .
But no matter the outcome of your options contract, you can get paid to wait for the price of your stock to rise to your strike price, often more than once.
Take Capital Gains
As I mentioned above, capital gains are another way to make money on stocks. Capital gains are earned when you sell an investment for more than you paid for it. You may decide to sell some shares outright and lock in your profits that way, or you may be required to sell 100 shares because of a call.
If you sell some of your shares for more than you paid, the average adjusted cost for the remaining shares in your account is effectively lowered. Remember, your gains are unrealized until you sell your investment. You “lock in” a gain (or a loss) when you sell.
Note: Capital gains are considered short term or long term, and come with different tax implications. I want you to be aware of these concepts, but I can’t address your individual tax situation. If you have questions about your specific situation, you should check out the IRS website or consult a tax professional.
A Comparison of Two Campaigns, With and Without Options
Example A: Using Options to Lower My Costs and Increase Profits and Dividend Yield
Stock XYZ is selling for $32/shares and pays a dividend of $0.25/quarter, or $1/year, per share, for an effective annual yield of 3.125%.
I buy 150 shares of XYZ, paying ($4800).
I sell a put, expiring the next month, with a $30 strike price. I receive $40 for the put. I hold $3000 cash in my account, in case I'm assigned to buy the stock.
I now own 150 shares, and my out of pocket cash is ($4760). ($4800) + $40 = ($4760). ($4760)/150=($31.733)/share.
A month later, the share price drops to $29/share. When the put expires, I am assigned to buy 100 shares, paying $30/share, or ($3000).
I now own 250 shares, and my out of pocket costs are ($7760). ($7760)/250= ($31.04)/share.
I sell a covered call with a strike price of $32, expiring in two months, and receive $65. My out of pocket costs are reduced by $65, to ($7695). My average cost per share is reduced to ($7695)/250= ($30.78)/share.
The next month, the shares go ex dividend. I receive $0.25/share * 250 shares, or $62.50. Since I have set my dividends to reinvest automatically, the funds are used to buy 2 more shares of the stock at the current share price of $31.25.
I now own 252 shares, with an out of pocket investment of ($7695). My average cost per share is ($7695)/252=($30.54).
The next month, the share price rises to $34. At the end of the covered call contract, I'm assigned to sell 100 shares for $32, and receive $3200 cash in my account.
My out of pocket costs are now ($7695)+$3200=($4495).
I own 152 shares. My average cost per share is ($4495)/152= ($29.57)/share.
I sell another covered call with a strike price of $35 and receive $75 cash. My out of pocket costs are now ($4495)+$75=($4420), and my average cost per share is ($4420)/152 shares=(29.08)/share.
The next month, the share price is $32, which is right where I started. The call expires worthless, and no shares change hands.
My out of pocket costs are still ($4420). I still own 152 shares at an average cost per share of ($29.08).
The current net liquidating value of the position is 152(shares)*$32/share=$4864.
I have an unrealized profit of $444. Current value-total cash invested=unrealized gain. $4864-4420=$444.
For the next year, my projected dividend income from the position is $1/share. If I don't reinvest my dividends, I'll bring in $152, or almost 3.44% of $4420.
If I reinvest my dividends, my dividend income will increase with each payment, as I continue to add more shares to the position.
I have spent about 20-30 minutes each month for five months, placing the orders for these trades, monitoring them and entering them on my spreadsheet.
Example B: What would have happened if I set up the same position without using the options?
Stock XYZ is selling for $32/shares and pays a dividend of $0.25/quarter, or $1/year, per share, for an effective annual yield of 3.125%.
I buy 150 shares of XYZ, paying ($4800).
Two months later, the stock goes ex dividend. I receive $0.25*150 shares=$37.50 in dividend income.
My dividend automatically reinvests to buy me 1.2 shares at $31.25/share.
My average cost per share is ($4800)/151.2=($31.746)/share.
One month later, the share price is $32, or exactly what I paid for it.
My out of pocket costs are ($4800). I own 151.2 shares at an average cost per share of ($31.746).
The current net liquidating value of the position is 151.2(shares)*$32/share=$4838.40.
I have an unrealized profit of $38.40. Current value-total cash invested=unrealized gain. $4838.40-4800=$38.40
For the next year, my projected dividend income from this position is $1/share. If I don't reinvest my dividends, I'll bring in $151.20, or 3.15% of the $4800 cash I have invested.
If I reinvest my dividends, my dividend income will increase with each payment, as I add more shares to the position, but the gains will be significantly less than those in Scenario A.
I spent less than 30 minutes setting up this position in January and have not monitored it since then.
I put the two scenarios in a spreadsheet. You might have to zoom in to see the numbers.
The judicious inclusion of options as part of your investment portfolio can actually reduce your risks while increasing your returns. No hype, no get-rich-quick promises; just pay a little less for stocks you want to buy and get a little extra when you are ready or willing to sell, increasing the effective dividend yield on the shares you keep in your account.
You can learn more about low risk investing strategies by signing up with your email for a free, 70-page ebook, Introduction to Options or Introduction to the Stock Market. In addition to the ebook, I'll send you special offers and access to exclusive content to help you on your investing journey.
If you want to read the whole book, it's available on Kindle. And if you prefer video content, check out my Udemy courses.
I hope you'll let me know what you learn and how you use the information.
