Chris’ note: This week, we’re taking a break from our regular Daily Cut fare. And I’m sharing with you instead a series of wealth-building essays from other members of the Legacy Research team.
For most folks, 2022 has brought painful losses – not just from the bear market, but also from record-high inflation. And here at Legacy, we’ve been working extra hard to spotlight strategies you can use to protect and even create wealth in this type of environment.
We’ve also been building out the Legacy team. Today, you’ll hear from one of our latest hires, Andrew Packer. He’s an expert on unlocking fat income streams from the stock market. And Teeka Tiwari has tapped him for the chief analyst role at our Palm Beach Letter advisory.
The most common way to earn income on shares is to buy dividend-paying stocks. But as you’ll hear from Andrew below, you can still force income out of stocks that don’t pay dividends.
Today, I’m sharing a simple investment strategy you can use to create a growing income stream over your lifetime.
It’s called yield on cost.
As you probably know, some stocks pay out regular income to shareholders as a dividend.
You calculate a stock’s dividend yield by dividing the dividend per share by the share price. Then, you multiply the result by 100 and add a percent sign.
So if a stock is trading at $20 and pays out a $1 dividend every year, its dividend yield is 5%.
But to find your yield on cost, you divide the current dividend payment on a stock by your original buy price. Again, then you multiply that by 100 and make the number a percent.
If you buy the right kind of dividend-paying stocks, your yield will rise over time against what you originally paid for them.
In some instances, your yield on cost will rise well into the double digits.
I used this strategy during the 2008 global financial crisis to buy blue chips like McDonald’s (MCD) and the Walt Disney Company (DIS) at discounts.
I bought MCD for $55. I paid $19 for DIS in 2009, close to the bottom of the 2007–2009 bear market. And I’ve seen returns of 380% and 510% on those positions thanks to big rises in the price of those shares.
But I’ve also been collecting steady income along the way.
Today, McDonald’s has a dividend yield of 2.1%. That compares with an average dividend yield of 1.7% on the S&P 500. That means MCD pays about 24% more than the average S&P 500 stock.
But that 2.1% yield is only half the story. Today, McDonald’s annual dividend payout is $5.52 per share.
So my yield on cost is over 10%.
But sometimes even the most reliable dividend-payers stop paying dividends.
That happened with Disney. It paused its dividend in 2020.
For many investors, a cut means hitting the sell button.
Not for me. I’m still earning steady income streams from my Disney shares…
I earn a “dividend” on my Disney shares through options – specifically covered call options.
When most investors hear about options, they imagine high-risk, complicated trades.
But selling covered calls on reliable blue chips isn’t so risky or tough.
Calls are bullish “side bets” on a stock. You profit when the stock price goes up.
Covered calls are options you sell on stocks you already own. You get upfront payments in the form of options “premiums.”
You get to keep that money no matter what happens with the trade.
And as long as you limit your sale to one contract for every 100 shares you own, you’re covered – as the name says.
The alternative, selling uncovered calls, sounds great in practice. But it could blow up your portfolio if the underlying stock rallies significantly.
You’d be on the hook to buy 100 shares per contract and deliver them to the buyer of the contract. Plus, you wouldn’t pocket any of the price appreciation.
We want to use options to lower our portfolio risk… not heighten it.
Here’s how that works…
First, pick a target price above the current share price. This is called the “strike” price. You should set it at a level the stock is unlikely to hit before the option contract expires.
A good rule of thumb is the strike price should be 10% to 25% higher than the stock’s current price.
Then you pick an expiration date about two to three months out.
Options lose value over time as they approach expiration – like the “best before” date on a milk carton. So I usually choose an expiration two to three months out to give me enough time to sell them before they “go bad.”
Then you pick up your upfront premium amount. This hits your brokerage account as soon as you sell your option.
Once you’ve sold your call, one of two things will happen…
The stock trades below your target when the option expires. If this happens, you keep your stock and the upfront payout you’ve already pocketed.
The stock trades above your target when the option expires. If this happens, you keep the upfront payout but sell your stock to the call option’s buyer for the strike price.
Now, there are some risks to selling covered calls.
If the stock goes to the buyer of the contract, you’ll miss any price appreciation above the strike price.
So if you love the stock you’re selling covered call options on, make sure to set the strike price far enough away from the share price. The premium income will be a bit lower. But your chances of losing the shares will be, too.
As I mentioned, Disney suspended its dividend in early 2020. It hasn’t reinstated it since.
But instead of selling my shares, I created my own “dividend” on the stock. I’m still collecting those payments two years later.
Right now, I could sell the October 2022 $135 calls on DIS for $2.40 per share. DIS trades at about $116. So my strike price is 16% higher than the current share price.
Multibillion-dollar blue-chip companies such as Disney don’t often see 10% rallies in two months. That means DIS likely won’t hit the strike price.
Each options contract covers 100 shares. I’d make $240 per contract by selling those covered calls. That’d be a 1.9% return in just two months.
That may not seem like much. But remember, the average yield on the S&P 500 is 1.7% a year. So that’s a nice chunk of income from a low-risk trade in a sixth of the time.
If I could make about $2.40 per share in extra dividend payments from Disney every two months, that’d be $14.40 a year. That’s an extra 11.8% return from the stock, on top of any price gains.
Let me be clear, though: Low risk doesn’t mean no risk.
There’s a chance Disney will continue to rocket higher. It released solid earnings. And investors like its plan to raise prices on its streaming service, Disney+.
If the share price goes above the strike price, I’ll lose my DIS shares along with any gains above the strike price.
But I’ve been using this strategy routinely over the past two years to churn out income on DIS… and I haven’t lost my shares yet.
Bottom line: If a stock stops paying a dividend, consider selling covered calls on your shares. It’s a strategy I’ve used to make back more than what I spent on my Disney shares.
Chief Analyst, Palm Beach Letter
P.S. Recently, Teeka identified an “Anomaly” in the market that can give you the opportunity to make crypto-like gains from the same blue-chips I suggest selling covered calls on.
It’s a chance to capture 21 years of market gains in as little as 90 days. And this past month, Teeka has used this strategy to book gains of 44.8%, 52.9%, and 61.1% on call options in just two weeks.
To learn more about this “Anomaly” and how you can profit from it, go here.