Wednesday, January 2, 2008

Wringing more income out of a portfolio

It’s cold today in Florida, almost as cold as today’s market action. In fact, it’s so chilly that my wife drove the car to our mailbox to pick up the mail! I decided to stay inside and blog about how a person can wring some income out of stocks that you aren’t ready to sell.

As the faithful reader will remember, I have been pessimistic about the market’s potential for the last 90 days and have lightened my equity risk substantially by selling positions, buying puts, and building a bond ladder. But I still have a portfolio of stocks that are defensive in nature and, hopefully, won’t be decimated as badly as the general market may be this year.

To maximize my return, or minimize my loss, on this portfolio I look to their dividends plus any revenue that I can garner from writing covered calls. Almost all pay dividends of between 1% and 2% and I can earn a like amount annually writing calls. Thus, most likely, I can earn 2% and 4% which either gives me a headstart on a good year or reduces my brusing if the year is a bad one.
I only write covered calls on stocks that I already own and like. I generally don’t buy a stock just to write the call. I never write a naked call where I don’t own the stock. Also, I only write them on positions that I don’t mind having them called away from me-so I have to be ready to pay the capital gains tax.

A quick example if anyone is interested. A stock sells for 70. You agree to sell it for 75 anytime up till February 20 in return for a premium of $1. So, if you would be content to sell at $76 within the next 2 months you can’t lose. Assuming premiums stayed about the same, you could do the same thing several times during the year which, in addition to the dividend, puts a nice floor under the stock’s performance.

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