How does dividend yield work

how does dividend yield work

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As it turns out, despite the summer swoon, income investors were the big winners in 2011.

While the Dow Jones Industrial Average finished the year with a gain of just 5.5%, the 100 highest-yielding stocks tracked by the Dow Jones – as measured by the iShares Dow Jones Select Dividend ETF (NYSE: DVY ) – returned a market beating 11.73%.

Of course, the question today is whether or not that performance will carry on in 2012.

However, given the contentious nature of the U.S. presidential race, the ongoing turmoil in the Eurozone and the clouds hanging over the global economy, 2012 is looking like it will provide another great year for dividend investors.

"The problem with going for capital growth," Martin points out, "is that you very often don't get it, and then you've got nothing – the investment just sits there."

By contrast, Hutchinson added, "Dividends are easy… All you have to do is figure out which companies have genuinely solid business models that aren't going away."

Options Strategy: Boosting Your Yield With Covered Calls

What's more, if you're willing to put in a little extra time and make use of a proven strategy involving call options. you can safely double, triple, or even quadruple the amount of income you receive from your dividend-paying stocks – even if the share price does absolutely nothing.

The technique is known as "writing covered calls ," and implementing the strategy is quite simple.

All you do is sell (or write) one out-of-the-money call option – i.e. one with a strike price higher than the stock's current market price – for each 100 shares of the stock you own (the underlying security ).

The call is said to be "covered" because you own the underlying shares. As a result, you don't have to put up any added money or "margin " in order to make the trade.

All of the money you receive for selling the calls – the "option premium " – is yours to keep regardless of what happens to the price of the underlying stock.

This "option premium" is then added to your overall gains, boosting the yield you are set to earn from the dividend.

Here's how it works in practice:

For example, let's say you own 300 shares of stock in Abbott Laboratories (NYSE: ABT ), trading this week around $55.70 with an annual dividend of $1.92 a share. That equates to a current yield of 3.45%.

However, you decide that you would like boost your cash flow by writing covered calls.

What you'd do is write three covered calls against your 300 shares, choosing to sell the out-of-the-money $57.50 strike price calls with a May 18, 2012 expiration date.

Early Wednesday, those calls – with just four months of life left – were quoted at $1.00 a share or $100 per 100-share contract. That means selling three of them would put $300 in your account – minus a modest commission of, say, $15.

Thus, you'd be adding roughly $285 to the quarterly dividend of $144 you will receive on your 300 shares of Abbott stock – nearly tripling the amount of income from your position.

So long as Abbott's stock price stays below $57.50 until May 18, you get to keep both the stock and the premium received for selling the calls, as well as collecting the dividend.

And, since you can repeat this strategy every three

months or so – adding an estimated $1,140 to the annual dividend payment of $576 ($1.92 x 300 = $576) – your annual cash flow will rise to about $1,716.

That equates to a one-year yield of 10.26% ($1,716 / 300 x $55.70 = $16,710 = 10.269%).

What about the risks? ….

Well, if Abbott's stock price falls, you suffer the same loss you would have faced by just holding the stock alone. But the premium you received from selling your covered calls helps offset part of the loss, softening the blow.

The bigger risk is that you might have to sell your shares at a price higher than where they're trading today. That is, if ABT is priced above $57.50 on May 18 and the calls are exercised, you'll have to sell the stock at that price, forfeiting any gains on the stock above that level. However, selling there would still give you a gain of $1.80 a share (or $540) from today's price.

What's more, you'll also earn the $1.00 a share ($285 net) you received for the options, giving you a total profit of almost $3.00 a share. Hardly an unpleasant outcome.

You would, of course, forfeit any future ABT dividend payments, but you could continue to earn revenue from Abbott Labs using the money you received to finance an alternate strategy known as "selling cash-secured put options " (which we'll detail in an upcoming Money Morning article) until ABT pulls back to an attractive level for repurchasing the stock.

A Second Way to Look at Covered Calls

This strategy can also be used to make stocks with fairly low yields more attractive to income investors.

For example, discount retailer Family Dollar Stores Inc. (NYSE: FDO ). recent price $53.83, is a fairly attractive growth candidate given the still-high jobless rate and the iffy economy, which translates into more budget-conscious customers.

However, with an annual dividend of just 72 cents, FDO offers an annual yield of just 1.33% – hardly appealing to income investors.

But thanks to the extended period of market volatility, FDO options are carrying high premiums. To be precise, the April $57.50 call, almost $4.00 a share out of the money and having just three months of life left, was quoted at $1.10, or $110 per contract.

Thus, if you bought 300 shares of FDO stock at the present price, paying $16,149, then sold three April $57.50 calls, the $330 in option income plus the $54 quarterly dividend would increase the annualized yield on Family Dollar to roughly 9.51%. That's almost as good as what you would have gained in our Abbott Labs example.

This covered call strategy is also remarkably versatile. It can be used to produce an income stream from stocks that don't even pay a dividend, and it can be structured to provide a wide variety of yields and cash payouts by adjusting the choice of strike prices and expiration dates.

So, if you want to generate more income and higher yields from your stock holdings, consider covered calls.

The tables for options on most stocks are available on both Google Finance and Yahoo! Finance, as well as most brokerage firm trading platforms, and checking them can help you calculate how selling covered calls can boost your investment returns.

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