The 1st quarter of 2009 saw dividend decreases outpacing increases, for the first time since 1955. Income investors are finding it increasingly challenging to find safe high dividend yields.
Free cash flow is an important measurement in assessing the safety of a company's dividend, as is the dividend payout ratio, which usually gives investors a good idea of how much of a cash cushion a company has after paying out dividends. With the exception of MLP's, LP's, and REIT's, beware of firms that have very high dividend payout ratios.
Olin Corp., (OLN), is a good example of a stock with a low dividend payout ratio. At a price of $13.56, OLN was yielding an attractive 5.99%, ($.20/quarter/share), as of April 23, 2009, with a dividend payout ratio of just 39%.
An easy way to gain even more yield out of this stock would be to sell covered calls options against it. As an example, using this strategy, you would buy a minimum of 100 shares at $13.56, and then sell the Jan. 2010 $15 calls against it for $1.70/share, which would give you an additional 12.53% yield. (Note: 1 option contract corresponds to 100 shares of the underlying stock).
Your total "static yield", (and downside protection), would then become 16.7%, for this 9-month investment term, (since you'd only receive 3 out of 4 quarterly dividends before the January 2010 expiration). This equates to an annualized yield of approximately 22.27%.
However, the covered call strategy also gives you a third potential for profit, via price appreciation. If OLN rises to or past $16.70, your shares will be assigned/sold, giving you an additional $1.44/share, (10.62%), in profit. The assignment process doesn't usually happen until on or near the expiration date, particularly with long-term LEAP calls.
If the OLN shares get assigned, your total profit would be $3.74/share, on a $13.56 stock, or 27.58%% for the 9-month term, which equals a 36.77% annualized yield.
The trading range for this example is:
Downside Breakeven: $11.26 ($13.56 less $2.30 dividend/call $)
Maximum Resale Price:$15.00
Static Profit: $2.30/share (22.62% annualized yield)
Assigned Profit:$3.74/share (36.77% annualized yield)
The static yield from the dividend/call $ gives you downside protection of 16.96% in this trade. "Static" refers to a scenario in which the stock doesn't rise enough for your shares to be "called away", (sold).
Obviously, there's no guarantee that the stock won't go lower than $11.26, but this strategy gives you much more downside protection than if you'd simply just bought the stock.
Your upside potential profit is limited to your total assigned yield, since you must still sell the stock at the $15 strike price if it gets sold away from you, even if it goes much higher than $16.70. However, earning a 36.77% annualized yield makes a very compelling case for using this strategy.
So, we've taken a stock that's yielding 5.99%, and increased its annualized yield to 22%-36%, almost 4-6 times the original yield, AND given ourselves 16.96% downside protection. All done in 2 simple steps.
Sound too good to be true? It isn't, but there's one essential element: Good research. Make sure you're investing in sound companies to begin with; cash-rich companies with strong earnings that can sustain their dividends. When it comes down to it, finding the best research, and harnessing it to the most powerful strategy is the holy grail for investors...
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