Financial Planning: The Income Portfolio

SYMBOL	Position	Cost	Current	Annual Div	Value	Div Tot
INTC	500	$30.93	$30.93	$0.96	$15,465.00	$480.00
SNY	700	$47.07	$47.07	$1.91	$32,949.00	$1,337.00
KO	700	$39.91	$39.91	$1.22	$27,937.00	$854.00
PG	400	$81.83	$81.83	$2.57	$32,732.00	$1,028.00
DBD	600	$33.34	$33.34	$1.15	$20,004.00	$690.00
CVX	300	$101.62	$101.62	$4.28	$30,486.00	$1,284.00
ETR	500	$74.65	$74.65	$2.60	$37,325.00	$1,300.00
GE	1000	$25.04	$25.04	$0.92	$25,040.00	$920.00
COP	500	$61.64	$61.64	$2.92	$30,820.00	$1,460.00
PPL	1000	$31.80	$31.80	$1.49	$31,800.00	$1,490.00
F	1000	$16.20	$16.20	$0.60	$16,200.00	$600.00
MO	500	$51.39	$51.39	$2.08	$25,695.00	$1,040.00
					$326,453.00	$12,483.00

For the next nine months I’ll be paper trading the portfolio you see above. The total value is what I'm currently projecting for the roll-over IRA I'll start in January 2016. All dollar amounts shown in this post are "last price" as shown on March 15, 2015 (which would include any after market movement on March 13).

The combined dividend yield of 3.82% is about as good as you can get without venturing into things like MLPs or REITS. There’s nothing wrong with those types of securities as such, but I’m not comfortable with having them in my retirement portfolio. Preferred stocks are another high yield class of securities I’ve avoided for one important reason: this portfolio is designed to provide a steady income that can be supplemented by selling covered calls.

The methodology is relatively simple:

1.              Purchase quality stocks that have solid dividend performance

2.              Allow dividends to accumulate in cash

3.              Each month sell covered calls at the lowest “out of the money” strike

4.              At expiration re-evaluate any called positions and re-purchase or re-allocate

5.              Use the remaining proceeds and dividends, if any, to increase positions.

Purchase quality stocks that have solid dividend performance

This is actually pretty easy to accomplish. I started with the list of companies called "Dividend Aristocrats" - companies that have paid and raised dividends for at least 25 years.  I filtered that list by using my broker's research and rating system and then added other companies that were well rated and had excellent dividend yields. I have a cumulative yield of 3.82% - pretty good given that I haven't ventured into REITs, MLPs, or even preferred stocks.
  

Allow premiums and dividends to accumulate in cash

The usual approach to investing is to re-invest dividends. That makes perfect sense if you’re investing for the long term. But I’m investing for current income. All dividends and option premiums get swept into each month’s pile o’ cash. We won't need the money for normal expenses as long as my wife is still working so for at least a few years most of the dividends and option premiums will be re-invested - the following month. Because all this is happening in an IRA, there are no immediate tax consequences (all "short sale" transactions are classified as short term gains) unless I need to take a distribution for some reason - then the normal IRA distribution rules come into play.

Each month sell covered calls at the lowest “out of the money” strike price

Options
INTC	April 31.00	$0.82	$410.00
SNY	April 48.00	$0.65	$455.00
KO	April 40.00	$0.84	$588.00
PG	April 82.50	$1.10	$440.00
DBD	April 35.00	$0.35	$210.00
CVX	April 105.00	$1.30	$390.00
ETR	April 75.00	$1.85	$925.00
GE	April 25.00	$0.60	$600.00
COP	April 62.50	$1.72	$860.00
PPL	April 32.00	$0.60	$600.00
F	April 24 16.50	$0.32	$320.00
MO	April 52.50	$0.78	$390.00
		Premiums	$6,188.00
		Dividends	$1393.20
			$7581.20

This is where the fun starts. By writing out of the money calls I get current income and I get at least some of the profit if the share price increases beyond my strike price.  If a stock’s price drops below my purchase price I have to be careful to remember my cost basis and not write a call that would cause me to sell at a loss if the call were to be exercised.

Because I started this account with a rather substantial roll over, I'll get about two years worth of trading "on the house". After that I'll be paying whatever the normal commission is at that time.

Violating my "out of the money" rule is this month's GE call - it's $0.04 in the money. I decided to go ahead because the amount is very small in comparison with the option premium. Should the position be assigned I'll still clear $560.00 on the trade. This is almost certainly a tactical error but GE has been in the doldrums for several years and there's a very good possibility it will close below $25 in April.

Finally, notice the Ford call expiration is on April 24. There wasn't an out of the money call with any kind of premium value on the regular expiration date of April 17 but Ford's option market is very active and there are weekly options at more strike prices.

At expiration re-evaluate any called positions

On the weekend following the third Friday of each month I’ll know which positions have been assigned. If I still like the company I’ll place an order for the next trading day to replenish my position. If not, I’ll go back to the “Dividend Aristocrats” list and repeat my research.

Very occasionally something called "early exercise" can occur. This most commonly happens when the underlying is about to distribute a dividend and the value of the dividend is greater than the remaining time value in the option.

Use the remaining proceeds and dividends, if any, to increase positions

This phase is particularly important because it’s where I can reduce my cost basis.  Since I’m not re-investing dividends automatically, I have to make this decision each month.  The only rule is to purchase only in lots of 100 shares so I don’t have any assets that can’t have calls written against them. For example, if Ford drops to $15.20 I could buy 400 shares with my pile o' cash, reducing my cost basis to approximately $15.91. I might have to skip a month to get decent premium for a $16 strike price but that's the way this whole thing works: time is money. So...

For this first month I have $7581.20 in cash available (in March, only KO, PPL and MO pay dividends). Assuming I didn’t use some of it for another purpose I could increase my position in anything other than PG, CVX, or ETR. I could also hang onto it for another month if I wanted to increase my position in one of the higher priced stocks. If any positions are assigned I may also use some or all of the pile o' cash to re-purchase the underlying. We'll see on April 20 (and 27th).

EDIT 2015/03/17: I stupidly had all the dividends in my master spreadsheet paying on their ex dates rather than the pay dates. I've adjusted the amount of dividends received in the above charts.