Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

How To Generate an Extra Dividend Using Call Options

Say you own a great stock. It's a company you like and understand. You read the annual report, you scan its SEC filings, you follow it in the press. The only problem: It doesn't pay a dividend. You're willing to tie up some of your capital in its shares, but you'd like to see a tangible return in addition to the stock's growth potential.

Fair enough. The only problem is that these shares don't pay a dividend. The board of directors feels its best to use the company's cash to build its business, and things are likely to remain that way for years.
Wall Street doesn't have a solution to this problem. LaSalle Street does.

LaSalle Street runs through Chicago, nearly 900 miles due west of Wall Street. There you will find the Chicago Board Options Exchange, which is where you have to go if you want to create or expand a dividend on a stock.

This is a little complicated, and we'd better start at the beginning.

Say you are a baker. Your bakery turns out thousands of loaves of French bread each morning. Customers line up to buy your fragrant wares each morning. It's a great business, an honest trade, and you love it.

Thing is, you need a lot of flour. Tons of the stuff. Flour, of course, is made from wheat. And wheat, like all commodities, is subject to very volatile price spikes. In fact, you have a friend in Kansas who grows the stuff. He has to worry about frost, bugs, weeds and hail, none of which he can control. An untimely freeze across the Midwest can double the price of flour overnight, and you can take that kind of risk.

So you cut a deal with your friend. You agree to buy a certain amount of his wheat crop at a certain price during an agreed upon period of time. If the price of wheat, for whatever reason, goes above that, then you can buy his. You pay him a premium for this privilege, and you get price protection for your most important input cost. If you don't exercise your option, then he can sell his wheat to whoever he wants at whatever price he can get. He gets to keep your premium, sure, but you got to sleep at night without worrying about grain prices.

What you bought is a financial instrument that is traded every day. It's called an option, and it's a type of security known as a derivative. That's a very scary-sounding term but all it means is that the value of the option is "derived" from an underlying asset, in this case a certain number of bushels of wheat. An option can also derive value from currency, a market index or an individual stock.

Let's look at stock options.

A call option is the right to buy. The put option is the right to sell. Each type of option is listed for a given stock and specifies a "strike price" at which the option may be exercised. It also has an expiration date. A call option might give its holder the right to buy 100 shares of Microsoft at $50 until the end of January. If the price rises above $50, then you can exercise the option and buy the stock, which can then be resold for a higher price. You get to keep the proceeds, less what you paid for the option. As the buyer of the option, you have rights. The seller of the obligation, if the option is exercised, is obligated to fulfill his end of the bargain.

#-ad_banner_2-#Which brings us neatly back to where we started, with a stock you own that pays no dividend. If you want to generate income about the only way to do it -- short of lobbying the board of directors -- is to sell call options.

It works like this. You choose a price that either 1) you don't think the stock will exceed or 2) that you would be happy to accept for your shares. You then sell or "write" the option at that strike price. You collect the premium and the clock starts ticking. If the price stays below the strike price and the option expires, then you have collected premium that looks a lot like a dividend.  If the option is exercised, you sell your stock, ostensibly at a profit, and still get to keep the premium.
 
This type of option is known as a covered call. It is "covered" because you own the underlying shares. If they option is exercised, then you sell something you already own. It is possible to write "naked" calls, too, on shares you don't own. The risk here is significant. In fact, it's unlimited, as a stock price could theoretically rise forever. But writing covered calls is a relatively conservative income strategy. You can even do it in a self-directed IRA.

A couple of points: Options trading is very complicated. The concepts can be counterintuitive and the math can get out of control, with a lot of scary formulas with lots of Greek letters. If you are interested in options trading, talk to a broker you know and trust before you start buying or selling these contracts. Options can be a conservative way to generate an income stream, but they can also add significant risk to your portfolio. A lot of sites will offer information and practice trading accounts, but talking to an expert is the most prudent first step.