Which one comes out on top?
Dividend investing and selling covered calls are two of the most popular ways to generate income from the stock market while holding onto your shares.
Here is the video version of this article in case you are interested. The rest of the article is below.
Dividend investing is simple. Buy reliable dividend stocks that have solid payout ratios and a tendency to increase the dividend payment each year. Continue to reinvest the dividend to get more shares and compound your return over time.
Dividend yields can get tricky. Some investors chase high yield stocks that aren’t on stable ground. The result can be a 5% dividend yield for a stock that drops 10% within 1 year. No matter how good it may feel to receive the dividend payment, that position would still be a net loss of 5%.
Dividend investing is a great strategy for people who want to make extra income from the stock market with a set it and forget it strategy…similar to index funds.
If you want to beat the average return of the market and have some extra time to look at the stock market, a covered call strategy can yield additional income.
There are a variety of covered call strategy…
— Selling covered calls each week that are out of the money and likely to expire worthless. This strategy nets the highest premiums, but a sudden surge in the stock will force you to sell your 100 shares at the strike price or buy a call to close out the covered call position
— Sell a very far out of the money covered call that expires in a month. This strategy significantly increases your upside and the likelihood of you keeping your shares. You earn a lower premium with this strategy, but you increase your chances of the covered call expiring worthless. Some investors will close out this position by buying the same call 2 weeks beforehand if they made enough money.
— Sell covered calls that are far out of the money and expire on the same day. While premiums are lower, there’s a low chance of the option getting exercised. I’m not a fan of this strategy because a stock could suddenly surge in value due to a catalyst, but it is a popular strategy for the SPY ETF which has 3 expiration dates for its options each week.
You could be more cautious and sell a covered call of Apple stock at the 250 strike price for an instant $187 (I’m using the midpoint for this example) that expires in September 2021. This opens the door to incredible potential upside (the stock would have to more than double to reach the strike price), and it crushes the annualized dividend of $0.82/share.
Assuming you have 100 Apple shares, you would earn $82/year from the dividend versus $187 from this cautiously positioned covered call. You can set closer expiration dates and strike prices to make far more than $187 in a year’s time.
The issue with covered calls is that they cap your potential gain. Timing matters more if you’re selling covered calls than just collecting the dividends. However, call premiums crush what you would earn from dividend stocks.
Over the long-term, it’s better to retire exclusively with dividends if you could. However, the extra premiums you earn from options will propel you to retirement sooner than the dividend payments.
And if you don’t want to look at your portfolio for 30 minutes each day, dividend stocks make more sense than covered calls.