Last week I introduced the subject of generating cash from your stock portfolio. Not only is that a worthy goal, but I've read that dividend paying stocks outperform the market by 1% to 1.5% per month during downturns. This sounds reasonable to me. Why would someone sell their dividend paying stocks if they could make 20% to 30% a year even in a bear market?

Let's see how this might be done. First of all, we need to find an acceptable dividend paying stock. We can do this by simply accessing Stock Viewer and sorting by YSG Desc. As of yesterday, Thursday, 09/04/08, Cal-Maine Food, CALM, was in the top spot. Although it now has an "S" rating and I wouldn't buy it at this time, I want to keep my eye on it because it's making a ton of money and has an excellent Dividend Safety, DS, rating of 87. So let's use it as an example.

CALM closed yesterday at $34.50 per share and is paying cash dividends at the rate of $2.06 for a yield of 5.97%. If I were to buy these shares on margin, the effective DY would be twice as high, i.e., 11.94%. Of course I would have to pay interest to my broker on the borrowed funds, but the interest expense is tax deductable. Although I'm already looking at a juicy return, how could I get more? I'd sell some out-of-the-money Covered Calls. Yahoo!Finance shows that CALM had its last ex-dividend date on July 28, 2008, so I'd assume that its next declaration will be made in late October. Therefore, I'd be selling the November 40 Covered Calls, which are currently trading at $1.75 per share.

Here's how this trade would work: I would buy 100 shares of CALM on margin for about $1,725.00, not counting commissions or interest and I would sell one CALM November 40 Call Option @ $1.75 per share. My account would be charged $1,725.00 for buying the stock and be credited $175.00 for selling the option. The net charge would $1,550.00 not counting commissions or interest. Around the middle of November, my account would receive a dividend credit of about $51.50. The total income from the sale of the Call Option and receipt of the dividend payment would be about $226.50. This would give me a quarterly return of 13.1%. If I could do this four times a year, my annualized rate of return would be 52.5%, not counting commissions and interest.

This sounds great, but there are several other things that can happen to this trade. For example, the stock's price could rise prior to the ex-dividend date and the stock could be called at $40.00 per share. Although I wouldn't get the $51.50 dividend payment, I'd make about $500 on the stock and get to keep the $175 option credit too. This is not a bad deal.

If, on the other hand, the stock's price fell, I'd have to make some decisions. I could hang on to the stock, collect the dividend and option premium, and repeat the process again the next quarter. But that's no fun. I usually buy back the Call Option at a much lower price than I sold it for; then get more income by selling another Call Option at a lower Strike Price. This technique invokes the risk of getting called out of your stock at a price lower than your purchase price, so I suggest that you practice it with only small amounts of money before using it with serious money.

Incidentally, did you know that most of the market's historical gains have come from dividends? Maybe you've heard that selling covered Calls was the most frequently used option trade. Both generate income. Put them together and you have the Cash Machine, Part II.

P.S. Terra Nitrogen, TNH, closed up $8.51 today and is up over $14.00 since I mentioned it last week.