Despite what most investors think, owning shares of strong companies that pay great dividends is not the secret to higher yields.

There’s a far better strategy…

Buy only the companies that you want to own for some length of time, and then sell call options against your shares.

It’s known as “covered call” investing – and here’s how it works…

Each time you sell a call option against your shares, you earn cash called the “premium.”

That premium accomplishes two things:

  • It puts cash in your pocket the minute you patch through the trade.
  • It reduces your cost in the shares.

Both events increase your yield.

For example, say you buy shares of Microsoft (Nasdaq: MSFT), which was recently trading at $30.50 per share.

[ad#Google Adsense 336×280-IA]The company presently pays an annual dividend of $0.80 per share, which gives you a yield of around 2.6%.

But now look at what the Microsoft January 2013 $35 call options are paying – $1.

This means that if you choose to sell the options, you earn a premium of $1 per share for each share of MSFT that you own.

So if you own 1,000 shares, by selling the call option, you get $1,000 in your account, immediately.

Effectively, you’re accomplishing another two things…

  • You earn cash, which reduces your cost in MSFT by $1 per share. Going forward, your new yield is also higher, since your adjusted cost basis is lower.
  • If you just hold the shares, your MSFT dividend is $0.80. But by taking in an additional dollar, you effectively take the cash that you receive from the position from 2.6% to 5.9% – more than double!

Pretty good deal, eh?

However, I would be remiss if I didn’t mention the downside aspect of this trade.

Namely, when you sell a call option on a stock that you own, you’re obligated to sell the shares at the strike price of the option that you sold.

Let’s refer back to our MSFT example again…

The strike price is $35 and MSFT is currently at $30.50, which means that your new cost after banking the premium you received for selling the option is $29.50 ($30.50 minus $1).

Your obligation to sell comes in if MSFT closes above $35 by the options expiration date.

If that were to happen, you’d still enjoy a nice capital gain, but the downside to covered call investing is that there’s a firm limit on the upside.

As long as MSFT closes at $35, you’re golden. But anything higher than that and you’re losing out on gains.

Now, as downsides go, that’s not so terrible. When your loss merely amounts to “potential gains” and you’re still making money, things could definitely be worse.

Bottom line: Covered call investing on strong dividend-paying stocks is one of the best hidden strategies that you can use to boost your yield. Sometimes by more than 100%.

In addition, you can also use this strategy in any self-directed retirement account that allows you to trade stocks, which means that you can enjoy those extra “dividends” tax deferred!

Ahead of the tape,

Karim Rahemtulla

[ad#jack p.s.]

Source: Wall Street Daily