Combining high dividend yields with covered call options

New Strategy

Today, I would like to discuss a new strategy that I have been using to increase my passive family income. Back in February (2008), I wanted to start purchasing stocks that paid a nice dividend to help supplement my family’s monthly income. With all the unknowns in the U.S. Economy and a recession lurking, picking a good stock that I felt comfortable with was extremely difficult. My primary focus was to find an energy stock that paid a steady monthly dividend. After researching several possibilities, I decided to begin purchasing shares of HTE (Harvest Energy Trust). Harvest Trust Energy is a Canadian Royalty Trust (Canroy) who specializes in the exploration and development of petroleum and natural gas.

History of my HTE purchases (as of April 30, 2008)

• 02/20/2008 – Purchased 30 shares of HTE for average price - $25.07
• 03/04/2008 – Purchased 20 shares of HTE for average price - $23.50
• 03/17/2008 – Purchased 25 shares of HTE for average price - $23.17
• 03/20/2008 – Purchased 50 shares of HTE for average price - $22.14
• 04/17/2008 – Purchased 25 shares of HTE for average price - $24.12
• 04/23/2008 – Purchased 50 shares of HTE for average price - $23.01

GRAND TOTAL INVESTMENT – 200 shares of HTE with an average share price - $23.31

After I began purchasing shares of HTE, I decided that I wanted to expand my passive income for owning these shares beyond the monthly dividend. I began researching the possibility of selling Covered Call options to increase my monthly cash flow. Unfortunately, I only owned 125 shares at the time and selling 1 Covered Call (1 call = 100 shares) did not make much sense. So I decided to increase my position to 200 shares so that I could sell 2 Covered Calls, which would bring in additional income. The details below show the passive income generated from owning shares of HTE through April 30, 2008.

• 04/15/2008 – March Dividend received - $18.73 ($22.04 less $3.31 Foreign Tax)
• 04/23/2008 – Sold 2 May $22.50 Covered Call Contracts for $.80 apiece - $151.99

GRAND TOTAL PASSIVE INCOME - $170.72 (through April 30, 2008)

After factoring the price of my HTE investment with the Passive Income earned through April 2008, the average share price on the investment (commissions factored in) is:

200 shares of HTE @ $22.46 / share

Planning for the month(s) ahead

You may notice that I currently own 200 shares of HTE and have also sold 2 Covered Call contracts for the May $22.50 strike price. The current price of HTE is just below the $22.50 strike price which means that on the third Friday in May, I stand chance to lose my 200 shares for $22.50. If you notice above, I have calculated my average share price for the 200 shares at $22.46 (after factoring in dividends earned and proceeds from selling the 2 Covered Call contracts). Assuming I take no action and the share price of HTE is higher than $22.50, I stand to make $8 from owning this stock since February. Not a favorable return for a $4,662.35 investment.

As the weeks and days grow closer to the 3^rd Friday in May, I will be monitoring the stock price so that I can take action to “stay in the game” with the stock. The list below defines my strategy for the month of May depending on the stock price.

• HTE is below $22.50 / share - If the HTE share price is well below the strike price of $22.50, then I will take no action and wait to sell additional June calls.
• HTE is above $22.50 / share - If the HTE trades at or above the May strike price of $22.50, I will purchase back the two Covered Call contracts (HTEEX – May $22.50) I sold and sell two new Covered Call contracts for June (HTEFX – June $22.50). These two transactions will allow me to “stay in the game” with this stock while continuing to receive the monthly dividend and making some additional income along the way. If you notice, the June $22.50 Calls are higher than the May $22.50 calls which will result in positive cash flow for this transaction.

Lessons Learned

Although I am happy with my investment into HTE and the Passive Income that I have earned from the stock, I wanted to include some lessons learned on my purchases, so I can learn from my mistakes. I like to work for process improvement in my trading and investments so I don’t make the same mistakes twice. The following lists the lessons learned from HTE:

• Buy in larger increments - Buying in increments lower than 50 does not make a lot of sense. I made 4 of my 6 purchases of HTE with fewer than 50 shares which drives up the average share price with commissions factored in. I should have been more disciplined with my purchases setting aside the funds to buy increments of 50 or more instead of making several smaller purchases.
• Have a long term goal - Define my goal ahead of time. My first 3 purchases of HTE were basically random in nature without any goal in mind. I knew I liked the stock and wanted the monthly dividend, but did not really have any focus on the longer term. It wasn’t until my 4^th purchase of the stock that I knew I wanted to sell Covered Calls against the stock to generate additional positive cash flow. That purchase pushed me over the 100 shares, which would allow me to sell a Covered Call (remember – 1 option contract = 100 shares).
• DRIP - When I made my first few purchases, I knew that I wanted to re-invest the dividend income back into buying more shares of the stock. Unfortunately, I did not sign-up for the Dividend Reinvestment until after the first monthly dividend was distributed. This resulted in receiving the monthly dividend payment, but it wasn’t invested directly back into the stock.

Giving Credit

I am a firm believer in giving credit where it is due. I came across the stock pick of HTE from reading several posts on the livingoffdividends blog which provides excellent material on dividends and Canroys. I still completed my due diligence on the stock but may not have come across it without the help of this site.

Final Thoughts

The strategy I am using is nothing new to the investment world, but is new to me. I have found it to be a useful strategy to date but will continue to work on improving it while noting my lessons learned. At the beginning of each month, I will post activity for the prior month for my shares of HTE, along with my lessons learned and steps for additional improvement.

Sincerely,
passivefamilyincome

Tagged as: covered calls, Dividends, stocks