Create a 9-percent "Dividend" on a Blue-Chip by Selling Covered Calls

Some investors buy large cap stocks, the ones that usually don't move too much in the short or intermediate term, and they sell far out of the money covered calls three or four times a year in order to increase the "dividend" that they are receiving. If that stock already pays an actual cash dividend of 3 or 4 percent, the investor can often collect another 6 or 8 percent per year by selling out-of-the-money covered calls without getting the stock called away.

If the stock does get called out, that investor would still make a positive return because the stock will probably have risen by 5 points or more in order to get called out. When that happens, the investor has collected the actual dividends that have accrued while he or she owned the stock, as well as the price increase between where the stock was when the trade was opened and the strike price of the covered calls sold.

For an example of selling far out-of-the-money covered calls on a blue chip stock, let's use Exxon Mobil (XOM). It's the largest stock in the world by market capitalization. It closed at 93.13 on October 10, 2007. Suppose the investor buys 100 shares of XOM at that price and then sells one of the January 100 calls (XOMAT), which could be done for 2.05 points at the close. The trade has slightly more than three months of time remaining, so it could be done approximately four times a year. If XOM finishes below 100 at January expiration, the investor gets to keep the entire 2.05 points of premium taken in. That's like getting an extra "dividend" of 2.20 percent during the next quarter. Repeat that three more times during a year and that investor has brought in nearly 9 percent of income from a blue-chip stock. The actual dividend yield on XOM is only 1.5 percent so this investor would be really enhancing the income flow.

If the stock runs up and closes above 100 at January expiration, it will get called out. The investor will lose the stock, but he or she will get to keep the 2.05-points of premium received for selling the call as well as the increase in the stock price from 93.13 to 100. That works out to a total profit of 8.92 points, or 9.6 percent, in less than three months. That's a great return in and of itself.

The worst case scenario would be for the stock to head lower right from the start and continue to dive. When something like that happens, the investor probably wants to get out and take a loss when it is still modest in size. Some stubborn investors rode Nasdaq stocks from triple digit prices down to almost nothing during the great bear market of 2000 to 2002. There's no reason to be that stubborn. If you have a trade that's not working, usually the best thing to do is to get out before it turns into a disaster. In the case of covered calls, some cheap out of the money puts could be bought to guard against the worst case scenario.