Introduction

Dividend investing is usually seen as the go-to strategy for those looking to grow their wealth over the long run. Let’s take it a step further: living off dividends in retirement and not being worried about how or when to pay the bills is a beauty that few investors achieve. With treasuries and corporate bonds yielding next to nothing and the risk of facing a huge opportunity cost if one does not invest in stocks, there’s a lot to worry about when it comes to investing your hard-earned money wisely and safely. Not being forced to touch the principal and continuing to compound your income makes your investing journey to financial independence a lot easier, but we still have to determine where to put our cash to work.

In addition to our weekly and monthly reports where we provide more active/dynamic and mid- to long-term investment ideas, we received a lot of questions regarding dividend investing. How do we screen for the best candidates with good momentum and how can we add a bond-proxy element to our portfolio utilizing options?

Preview Example: Altria (MO)

Looking at Altria, which is a solid dividend aristocrat, we see that the company has hiked the dividend 10.40% annually over the last 5 years. At face value, this might be worth checking out for a covered call writing system that relies on selling ITM calls.

(Click on image to enlarge)

(Source: Seeking Alpha)

January 2022 Expiration

Before we get into great detail on how the mathematics behind this strategy play out, I'd like to share with you the two expiration dates I'll be using in this article: January 2022 and January 2021. I've used the mid-price of the spread between the bid and the ask.

Also, I set the 3 expected dividend payments at $0.88, between now and January 2021 and 7 distributions between now and January 2022. This results in a dividend per share of $2.64 and $6.16 respectively.

(Source: Marketwatch)

$25 strike

The next bullet points highlight what the strategy boils down to if we opt for the $25 strike:

• The amount that the option is in the money and thus the intrinsic value that we're going to receive from the call buyer = $20.17 per share. This figure compensates us for the loss on the stock side, since we're obligated to sell at $25
• Our breakeven including the expected dividend distributions is $18.76, noticeably less than the current market value of the stock: higher chances of success/a lot of downside risk protection
• Our cost basis is being bought down from $45.17 to $25 (strike price); this increases our percent return
• Adding the dividend amount of $6.16 to the time value component of $0.08 per share leads to our actual profit. We're guaranteed the time value return as long as shares do not depreciate below $25 by expiration Friday
• Our total return is 24.96% over a 707-day time period; buying Altria shares leads to a return of 13.64% based on the 7 expected dividend payments. So, we've increased our profit potential by more than 90%... Too good to be true? Let's see.
• There are, however, disadvantages to this strike: Altria's quarterly dividend is 88 cents per share, whereas the time value component left in the option is only 8 cents.
• Since the option is deep in-the-money, the option buyer is very likely to exercise our short call to capture the dividend prior to the ex-dividend date. We won't capture the dividend if that happens, but only a few pennies in time value. Therefore, the return potential is deceiving.
• When dealing with an in-the-money call, there's no possibility of participating in any share appreciation above the strike price as well
• If the share price goes up dramatically and there's virtually no more time left in the option, early assignment may take place even prior to the ex-dividend date. We can then unwind the position to generate new time value in a completely new trade (see the topic on 'Exit Strategies)

(Click on image to enlarge)

(Source: Option Generator's spreadsheets)

$40 strike

Let's have a look at the $40 in-the-money call:

• The amount that the option is in the money and thus the intrinsic value that we're going to receive from the call buyer = $5.17 per share. This figure compensates us for the loss on the stock side, since we're obligated to sell at $40
• Our breakeven including the expected dividend distributions is $32.01, noticeably less than the current market value of the stock: higher chances of success/a lot of downside risk protection. However, it is in huge contrast to our breakeven point for the $25 call
• Our cost basis is being bought down from $45.17 to $40 (strike price); this increases our percent return. Use the high cash premium (intrinsic value) to enter other new positions
• Adding the dividend amount of $6.16 to the time value component of $1.83 per share leads to our actual profit. We're guaranteed the time value return as long as shares do not depreciate below $40 by expiration Friday
• Our total return is 19.98% over a 707-day time period; buying Altria shares leads to a return of 13.64% based on the 7 expected dividend payments. So, we've increased our profit potential by more than 40%...
• There are, however, disadvantages to this strike: Altria's quarterly dividend is 88 cents per share; the time value component left in the option is a decent 1.83 dollars as the delta of the $40 is lower than that of the $25 call
• Although the option is in-the-money, the option buyer is not going to exercise our short call to capture the dividend prior to the ex-dividend date. So, we will capture the dividend distributions as long as the time value left in the option exceeds the quarterly dividend amount of 88 cents.
• Since LEAPs have very small time decay, the evolution of Altria's share price is going to determine how much time value there's left in the option we sold. If the cash distribution supersedes the time value component a day or two before the ex-dividend date, we have to roll out the option in order to be still eligible for dividend capture
• When dealing with an in-the-money call, there's no possibility of participating in any share appreciation above the strike price as well
• If the share price goes up dramatically and there's virtually no more time left in the option, early assignment may take place even prior to the ex-dividend date. We can then unwind the position to generate new time value in a completely new trade (see the topic on 'Exit Strategies')

(Click on image to enlarge)

(Source: Option Generator's spreadsheets)

Conclusion

The $40 call meets all of our criteria to generate time value and dividends while receiving $5.17 per share in intrinsic value to reduce our breakeven and net investment. The time value of the option needs to monitored in order for us to pocket future dividend distributions. The $25 call doesn't provide us with any time value at all but a lot of downside risk protection instead.

If the price of Altria goes up significantly, we won't be able to participate in any share appreciation. Also, a surging stock causes the delta of in-the-money calls to increase thereby pushing the time value component to virtually zero. That's going to impact our strategy of capturing the dividends. In that case, the returns indicated above may not be achieved. As this strategy is a possible bond replacement, a skyrocketing share price is not beneficial for an in-the-money call with a lower time value amount.

January 2021 Expiration

There are three expected dividend distributions until January 2021, each worth 88 cents.

(Click on image to enlarge)

(Source: Marketwatch)

$40 strike

Let's have a look at the $40 in-the-money call:

• The amount that the option is in the money and thus the intrinsic value that we're going to receive from the call buyer = $5.17 per share. This figure compensates us for the loss on the stock side, since we're obligated to sell at $40
• Our breakeven including the expected dividend distributions is $36.38, noticeably less than the current market value of the stock: higher chances of success/a lot of downside risk protection.
• Our cost basis is being bought down from $45.17 to $40 (strike price); this increases our percent return. Use the high cash premium (intrinsic value) to enter other new positions
• Adding the dividend amount of $2.64 to the time value component of $0.94 per share leads to our actual profit. We're guaranteed the time value return as long as shares do not depreciate below $40 by expiration Friday
• Our total return is 9.05% over a 336-day time period; buying Altria shares leads to a return of 5.84% based on the 3 expected dividend payments. So, we've increased our profit potential by 55%...
• There are, however, disadvantages to this strike: Altria's quarterly dividend is 88 cents per share; the time value component left in the option is a decent 94 cents as the delta of the $40 is pretty high
• Although the option is in-the-money, the option buyer is not going to exercise our short call to capture the dividend prior to the ex-dividend date. So, we will capture the dividend distributions as long as the time value left in the option exceeds the quarterly dividend amount of 88 cents.
• Since the January 2021 LEAPs have small time decay, the evolution of Altria's share price is going to determine how much time value there's left in the option we sold. If the cash distribution supersedes the time value component a day or two before the ex-dividend date, we have to roll out the option in order to be still eligible for dividend capture
• When dealing with an in-the-money call, there's no possibility of participating in any share appreciation above the strike price as well
• If the share price goes up dramatically and there's virtually no more time left in the option, early assignment may take place even prior to the ex-dividend date. We can then unwind the position to generate new time value in a completely new trade (see the topic on 'Exit Strategies)

(Click on image to enlarge)

(Source: Option Generator's spreadsheets)

$42.50 strike

Let's have a look at the $42.5 in-the-money call:

• The amount that the option is in the money and thus the intrinsic value that we're going to receive from the call buyer = $2.67 per share. This figure compensates us for the loss on the stock side, since we're obligated to sell at $42.50
• Our breakeven including the expected dividend distributions is $38.18, noticeably less than the current market value of the stock: higher chances of success/a lot of downside risk protection.
• Our cost basis is being bought down from $45.17 to $42.50 (strike price); this increases our percent return. Use the high cash premium (intrinsic value) to enter other new positions
• Adding the dividend amount of $2.64 to the time value component of $1.68 per share leads to our actual profit. We're guaranteed the time value return as long as shares do not depreciate below $42.50 by expiration Friday
• Our total return is 10.16% over a 336-day time period; buying Altria shares leads to a return of 5.84% based on the 3 expected dividend payments. So, we've increased our profit potential by 74%...
• There are, however, disadvantages to this strike: Altria's quarterly dividend is 88 cents per share; the time value component left in the option is a decent 1.68 dollars as the delta of the $42.5 is pretty high, but lower than the $40 strike
• Although the option is in-the-money, the option buyer is not going to exercise our short call to capture the dividend prior to the ex-dividend date. So, we will capture the dividend distributions as long as the time value left in the option exceeds the quarterly dividend amount of 88 cents
• Since the January 2021 LEAPs have small time decay, the evolution of Altria's share price is going to determine how much time value there's left in the option we sold. If the cash distribution supersedes the time value component a day or two before the ex-dividend date, we have to roll out the option in order to be still eligible for dividend capture
• When dealing with an in-the-money call, there's no possibility of participating in any share appreciation above the strike price as well
• If the share price goes up dramatically and there's virtually no more time left in the option, early assignment may take place even prior to the ex-dividend date. We can then unwind the position to generate new time value in a completely new trade (see the topic on 'Exit Strategies)

(Click on image to enlarge)

Conclusion

Both the $40 call and $42.50 strike price meet all of our criteria to generate time value and dividends while receiving a decent amount of intrinsic value to reduce our breakeven and thus net investment. The time value of the option needs to monitored in order for us to pocket future dividend distributions. The closer to current market value, the less likely early assignment for a particular strike price is going to take place.

Selling in-the-money covered LEAPs definitely enhances your returns. The $42.50 allows us to generate a total return of 10.16% over a 336-day time period; buying Altria shares leads to a return of 5.84% based on the 3 expected dividend payments. So, we've increased our profit potential by 74%...