Maximize Your Income: Adding Covered Calls to Your Dividend Portfolio

Jesse Anderson

Published on October 30, 2023

Investors have been drawn to dividend-paying stocks for generations. After all, you can’t go wrong with high-quality stocks that offer a combination of steady income and long-term appreciation. However, relying solely on dividends may not provide enough income, especially in volatile or sideways markets – and that’s where covered calls can help.

In this article, we’ll look at why dividend investors may want to consider covered calls and how to go about adding them to their income-focused portfolios. 

What Are Covered Calls?

A covered call is an option strategy where an investor holding a long position in a stock sells a call option against the same asset. In exchange, they earn an extra income from the option premium while still being eligible for dividends from owning the stock. The downside is that it caps the investor’s upside potential to the strike price of the call option.

For example, suppose that you own 100 shares of Acme Co., a stable, dividend-paying stock. Currently, the stock is trading at $50 per share, and it pays a quarterly dividend of $1.00 per share. Therefore, your 100 shares would provide you with $100 in dividends every quarter or $400 in dividends every year. While that’s not bad, you can do better with options!

Now, you decide to sell a covered call with a strike price of $55 and an expiration of three months away. In doing so, you receive an option premium of $2.00 per share, or $200 for your 100 shares. Without covered calls, you would earn just $400, but by writing this covered call four times a year ($200 x 4 = $800), you could receive $1,200 in total income!

Covered Call Pros & Cons

Financial professionals are fond of the adage, “There’s no such thing as a free lunch.” In other words, you never get something for nothing when investing in the stock market. But there are trade-offs that you might be happy to make while someone else would love the other side of the trade. For example, in this case, you might care more about income than capital gains.

There are several reasons to combine covered calls with dividends:

• Consistent Income Stream – Dividends and covered calls both offer income and combining them provides a more consistent and higher-income stream. Both dividends and call premiums are contractual payments that you receive.
• Downside Protection – The premium you receive from selling a call option can act as a buffer during market downturns, providing some level of downside protection. For instance, in the option diagram above, the breakeven point moves lower.
• Better Returns in Sideways Markets – In flat or sideways markets, stocks might not provide any meaningful capital gains. However, the additional income from selling covered calls can improve overall returns in these scenarios.

That said, there are a couple of downsides to keep in mind:

• Opportunity Cost – By selling a covered call, you limit your upside potential to the strike price of the option. So, if the stock surges, you will miss out on any capital gains beyond the strike price, which can be substantial.
• Tax Implications – The tax treatment of dividends and options can differ. For example, most option income is treated as ordinary income while qualified dividends may be taxed at the lower capital gains tax rate.

When deciding whether to add covered calls to your portfolio, you should carefully consider these trade-offs and make sure they’re right for you and your goals. It is also worth having a discussion with your financial advisors to ensure you’re on the same page while discussing potential tax implications with your accountant.

How to Get Started

Many dividend investors have a long-term portfolio and either take dividend payments as income or reinvest them to reap the rewards of compound growth (e.g., through a dividend reinvestment plan, or DRIP). In many cases, it’s relatively easy to overlay a covered call strategy on top of these kinds of portfolios.

Before getting started, you’ll need to make sure that your broker supports covered calls. In some cases, you’ll need to upgrade your account to trade options, which involves signing special disclosures. Since covered calls are a Level 1 strategy, most investors should be eligible to start trading them without any other special requirements.

The first step when adding covered calls to your dividend portfolio is to find suitable candidates. In particular, you should look for stable stocks with moderate volatility since too much volatility can make the strategy risky, and too little may yield insufficient premiums. You should also have a long-term bullish or neutral outlook since you’re risking having to sell the stock.

The next step is choosing the right call option by selecting an appropriate strike price and expiration date. While we could write a whole book on this topic, you should generally look for one-month expirations with near-the-money strike prices. The goal is to earn enough income to make it worthwhile without selling the stock at a low price.

A good way to quantitatively set the strike price is to look at the option’s delta. A call option with a 0.25 delta is interpreted by some traders to mean that there’s a 25% chance of it being above the strike price and a 75% chance of it being below the strike price at expiration. You can use it as a rough guide to avoid writing calls destined to be exercised.

Covered call screeners can be an invaluable tool during your research. For example, optionDash shows you everything from upcoming earnings dates that could introduce a lot of volatility to your if-called return in the event the stock price goes up. You can also assess the fundamentals of any company to understand the risk of ownership.

The final step is managing your covered call positions over time. Unlike set-and-forget dividend stocks, covered calls typically involve some hands-on management. For example, you may need to roll-up or roll-out your position if the stock price rises above the strike price and you don’t want to sell (e.g., to avoid incurring capital gains taxes).

It’s worth noting that option holders may exercise the option to capture a dividend, so if the price is moving toward the strike price as the ex-dividend date approaches, you may want to consider preemptively rolling it up or out to avoid an assignment. Or, you can simply avoid writing options on these dates if the stock pays quarterly dividends.

If you’re looking for some guidance in these areas, Snider Advisors’ free e-courses can help provide a base level of understanding and help you manage positions.

Tips & Best Practices

• Understand the Fundamentals – Before writing covered calls, make sure you understand the fundamentals of the underlying stock and the mechanics of call options so that you’re ready to handle any situation that arises.
• Consider the Context – Make sure you understand any upcoming factors that could influence volatility, such as earnings or other important news. Sometimes, options look very attractive because the market is pricing in one of these events.
• Keep Accurate Records – Keep track of your transactions, premiums received, strike prices, and expiration dates. That way, you can assess the effectiveness of your strategy over time and ensure that you’re ready for tax season.
• Monitor Your Positions – Covered calls involve more monitoring than typical dividend stock portfolios. If you see the stock price rising toward your strike price, you may need to “Buy to Close” the call or roll your option to prevent it from being exercised.
• Talk to Your Tax Professional – Covered calls will impact your tax situation, so it’s worth discussing your strategy with your accountant. That way, you can make other moves to offset any increase in ordinary income.

The Bottom Line

Covered calls are an excellent way to boost the income potential of a dividend portfolio. While not every dividend stock is suitable for covered calls, stable companies with moderate volatility can meaningfully boost income, improve returns in sideways markets, and offset losses in bear markets if executed properly. And that can make all the difference for income investors.

If you’re just getting started, consider Snider Advisors’ e-courses, and be sure to check out optionDash to help find the best income-producing covered call trades.