A Guide To Conservative Income Producing Option Strategies For Dividend Stocks
With interest rates at their lowest point in history, once safe income-producing assets such as 10- and 30-year Treasury bonds have seen their yields plunge to pitiful rates that are just high enough to keep up with inflation.
And while high-quality, dividend growth blue chips such as Pfizer (PFE), Coca-Cola (KO), Procter & Gamble (PG), and Johnson & Johnson (JNJ) are a great way of generating higher yields in this zero interest rate world, many investors are worried that the recent run up in such stocks means they are exposing themselves to larger short-term downside risk.
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In other words, fears of a potential dividend stock bubble have many people wondering where they can turn to generate solid returns while controlling downside risk.
Fortunately, stock options offer such investors some useful tools to meet their income, and risk control needs. And unlike what some people may think, not all options are high-risk, leveraged, speculative bets on the short-term movements in stock prices.
Let’s take a look at two low-risk, leverage-free, conservative income-producing option strategies to see how they can be used in concert with high-quality, dividend growth blue chips to help you reach your financial goals in this time of extreme market and interest rate uncertainty.
What are Stock Options?
Stock options are merely contracts in which the writer of the option (i.e. the person selling the contract), commits to buying or selling 100 shares per contract of an underlying stock, at a pre-determined “strike price,” if the share price is above or below that price by the option’s expiration date.
In other words, you can think of them as forms of insurance, in which the buyer of the option guarantees themselves the ability to buy or sell shares at a guaranteed price.
As the writer of the option, you serve as the insurance company, and receive an upfront premium for entering into the contract, and thus either tying up your shares, or your cash, for a predetermined amount of time.
There are Many Different Types of Options Strategies
Options are an incredibly versatile tool, with literally dozens of differing strategies for investors to use in any kind of market scenario, and with various different goals, such as capital gains, income, buying shares at a discount, selling them for a higher profit, hedging downside risk, or using leverage to boost gains.
Here are some common types of options and strategies you might have heard about before:
- Put spreads
- Call spreads
- Butterfly spreads
- Condor spreads
- Iron Butterfly spreads
- Iron Condor spreads
- Diagonal Call Spreads
- Various combinations of the above
While this list may seem daunting, in reality these strategies are mostly just combinations of the two most basic forms of options: puts and calls.
This article will focus on the two most basic, conservative income strategies based on these two options strategies: selling cash secured puts, and covered calls.
We’ll cover how, when, and who should use them, as well as the potential risks and rewards involved with both. We’ll also take a look at two examples, using two popular blue chip dividend stocks, Pfizer (PFE), and Johnson & Johnson, to show precisely how these strategies work.
For more detailed explanations of these, or other, more advanced strategies listed above you can click here.
Also note that, while buying calls and puts is also something you can do, and in fact is involved with many options strategies, it’s generally something for income investors to avoid, because studies show that about 75% of options expire worthless. In other words, the edge belongs to options sellers (aka writers).
Writing Cash Secured Puts
A put is a contract you can sell to generate income, OR to buy shares at a lower price. Specifically these contracts obligate you to buy 100 shares per contract at the stated strike price if shares trade below that level by the expiration date.
You can either write a naked put, or a cash secured put. Naked simply means that rather than setting aside enough money in your brokerage account to pay for the shares, you are using other assets, including shares of other companies, to cover the margin maintenance requirement.
This is a form of leverage that can easily get you in trouble should the stock move against you; potentially risking a margin call. That occurs if the value of your portfolio falls below a certain level, set by Federal regulations.
In the event of a margin call you either have to add more money to your account, or your broker will automatically sell your other holdings to come up with additional funds to meet the maintenance requirement.
In other words, this is a highly risky and speculative use of options that I advise all long-term dividend investors to avoid (see five other risks dividend investors should avoid here).
A cash secured put on the other hand, involves keeping the necessary money to buy the shares in your account and waiting to see whether the option will be triggered, or expire worthless; meaning the share price is above the strike price at expiration. In that case you keep the premium, which represents the income you generate from this strategy.
Writing Covered Calls
Calls are the opposite of puts, meaning rather than obligating you to sell shares at a certain strike price, they obligate you to sell 100 shares per contract at the strike price.
And like with puts you can write naked calls, meaning you don’t own the shares you might have to sell to the buyer of the call, or covered calls; meaning you own the shares and agree not to sell them before the expiration date.
Again, I highly advise only ever writing covered calls, as this avoids leverage, and ensures that you won’t ever receive a margin call, and forced liquidation. That’s when your broker automatically sells your holdings, at whatever the market price may be, to come up with enough capital to meet the maintenance requirement.
This kind of price incentive selling can result in selling at the exact wrong time (i.e. a market collapse), and result in large permanent capital losses.
Cash Secured Put Example: Pfizer
Say you believe that Pfizer is a great long-term dividend growth stock that is currently undervalued.
Because of this undervaluation the chances of Pfizer falling dramatically are lower, barring a strong, broad market correction. By selling puts you can buy shares at an even steeper discount, OR should shares stay at current levels or rise before expiration, you will generate potentially solid income.
The data below is as of October 6, 2016, when Pfizer traded at about $33.90 per share.
|Put Option||Premium / Share||Implied Buy Price||Discount To Current Price||Yield On Implied Buy Price||Premium Yield||Annualized Premium Yield|
|Nov 11 $33.5||$1.23||$32.27||3.8%||3.7%||3.8%||47.7%|
|Nov 11 $32||$0.38||$31.62||5.8%||3.8%||1.2%||13.2%|
|Mar 17 $33||$1.52||$31.48||6.2%||3.8%||4.8%||11.3%|
|Mar 17 $29||$0.55||$28.45||15.1%||4.2%||1.9%||4.4%|
Source: Yahoo Finance
If you don’t currently own Pfizer, and are looking to add some shares quickly, one way to use cash covered puts is to sell a short duration (in this case one month) put that is very close to the current price.
This is because shorter-term contracts usually pay more premium per day, and since you are looking to start an initial position, you don’t mind getting assigned shares if the share price drops below $33.50. After all it’s a great company, that’s already seemingly undervalued, and by selling a Nov 11th $33.50 put, you are getting $123 per contract up front.
That means that, should Pfizer fall under $33.50 over the next month, you would end up buying shares for $33.50 – $1.23 = $32.27. That’s a 3.9% discount to the already cheap shares, and a very nice 3.7% yield.
If the share price stays above $33.50, then the contract expires worthless and the $123 premium per contract represents a very nice return of $123 / $3,227 ($3,350 cost to buy 100 shares at $33.50 minus the premium already received). That’s equal to a 3.8% return over 35 days, or 47.7% annualized income yield.
Now keep in mind that this APR is only for the 35 days of the contract. To actually earn that high of a yield would require selling 12 such contracts, one each month, for the exact same terms, and each of them expiring worthless; a highly unlikely event. Nonetheless, a 3.8% return to sit on your money for a month is a very nice return; thus showing the potential income generating power of cash secured puts.
But let’s say that you already own Pfizer, and aren’t necessarily eager to buy more unless it’s at a much steeper (i.e. less likely) discount.
In that case you could sell a March 17 $29 put, which expires in just over five months, and pays $0.55 per share, or $55 per contract. While this is far less than the previous example, keep in mind that because this strike price is so “far out of the money” (below the current share price), the chances of actually buying these shares is less likely. Thus the risk of assignment is lower, and you earn a proportionally lower annualized yield of 4.4%.
Then again, that’s still a nice yield in today’s world, where even 50 year Swiss bonds can have negative yields. And don’t forget that if you do end up owning those shares it will be at a 15.3% discount to the current price, which means a 4.2% dividend yield.
Covered Call Example: Johnson & Johnson
The data below is from October 6, 2016:
|Call Option||Premium / Share||Implied Sell Price||Premium To Current Price||Premium Yield||Annualized Premium Yield|
|Nov 11 $119||$1.94||$120.94||1.5%||1.6%||18.4%|
|Nov 11 $124||$0.41||$124.41||4.4%||0.3%||3.6%|
|Apr 21 $120||$3.99||$123.99||4.0%||3.4%||6.4%|
|Apr 21 $125||$2.09||$127.09||6.6%||1.8%||3.3%|
Note that the premium offered for these calls is a lot lower than that of Pfizer’s puts. That is mainly for two reasons.
First, put premiums take into account dividends, while call premiums don’t. That’s to compensate you for the fact that by selling calls you are forgoing immediate ownership of the dividend paying shares.
With a covered call, you already own the shares and will get the dividend unless the share price is above the strike price and the owner of the option wants to exercise his right to buy your shares before the expiration date to get the dividend.
The second reason is that Johnson & Johnson is less volatile than Pfizer, as represented by its lower beta. There are several factors that affect option premiums but the largest is volatility. That makes sense because selling options is a form of insurance. Volatility is a proxy for risk, and as with insurance, premiums are higher if the risk is larger.
Let’s say you think that Johnson & Johnson has run up too far, too fast, and is currently overvalued, especially given its decent, but slowing dividend growth prospects (even despite its status as a dividend aristocrat).
Depending on whether you are overweight the stock and looking to unload quickly, or merely wouldn’t mind taking some profits off the table, you can use options to get a better selling price, or generate decent income if the share price either stays flat, or falls.
For example, let’s say you are overweight JNJ and have a decent alternative investment you wouldn’t mind investing in. In such a case you might not mind your shares being called away, especially since it would be at a higher price. So you could sell a November 11 $119 call, which pays $194 per contract and would result in a slightly higher sell price of $120.94.
Because you are giving up the ability to sell your 100 shares at the current value of $119.18 per share (as of 10/6/16), or $1,918, your yield for this month long contract is $194 / $1918, or 1.6%; equivalent to an annualized yield of 18.4%.
If the price of JNJ falls below $119 then you get to keep the premium, and your shares. If the price rises above it, then your shares will get called away (i.e. sold) to the option owner for $119. But since you received $1.94 per share in upfront premium your effective selling price is $120.94, a tad higher than what you could sell the stock for today.
But what if you aren’t so eager to sell unless it’s at a much higher premium? If you’re okay with trimming your holdings by 100 shares per contract you can sell an April 21 $125 call and receive $2.09 per share in premium. This is a $209 / $1918 = 1.8% return over 6.5 months, or 3.3% annualized.
While that doesn’t sound like much, remember that you should only sell a call if you think the underlying stock isn’t likely to rise very much by expiration. So in this case you think that the chances of JNJ rising are small, and you are getting paid 3.3% APR to not immediately sell your shares, and collect 1-2 dividends while you wait to see how the contract plays out.
Risks to Consider with Options
While selling cash covered puts and covered calls are among the two lowest risk option strategies available, nonetheless there are some risks involved you need to know about, specifically: event, financial, and opportunity risk.
Event risk is the probability that the underlying share price will move sufficiently to trigger the exercising of the option by its buyer. In other words, the chance that you either end up buying the shares or having them called away.
This is why it’s imperative not to write options in a speculative, short-term fashion, but rather as part of a broader, long-term, dividend growth strategy. Specifically I mean never write options on any shares that you don’t mind selling (for calls), or buying and holding for the long-term (puts).
Event risk is also why it’s best to use puts or calls with a certain goal in mind, such as buying discounted shares or trimming a position at a higher sale price. This way event risk becomes a feature, not a bug.
Financial risk is the risk of the share price falling far below the strike price. For example, with cash secured puts you could end up assigned shares at a substantial paper loss, right from the start. Now remember that you are still better off than had you simply bought the shares at the market price, since your cost basis is reduced by the premium.
However, cash secured puts are not a strategy that helps in the event of a massive market correction. If this is a major concern for you then I recommend you do further research on Bull Put Spreads, which involve buying a lower strike price put that acts as a hedge against a crashing share price. That’s because puts appreciate in value as shares fall, and so a put spread will cap your overall loss, or allow you to buy extremely discounted shares in the event of a market crash.
Finally, opportunity risk is involved with all option strategies, and is unfortunately not something you can avoid. This is the risk of option sellers’ remorse, when the share price moves in the direction you anticipated but to such an extent that you end up leaving a lot of profit on the table.
For example, when selling a cash secured put, the optimal profit occurs if the underlying share price is above the strike at expiration. However, imagine selling a put and then watching the market rally strongly, the undervalued shares of a company you like rocketing upwards. In such a scenario the premium you receive might appear pitifully small in comparison to the gains you miss out on by not simply buying the shares in the first place.
Similarly, selling a covered call has both financial and opportunity risk. Imagine that you sell a covered call on a stock you think is highly overvalued. If the share price then plunges then you potentially stand to lose a lot of patiently accrued unrealized capital gains.
Or the share price could soar far above the strike price, but your profit would be capped at the strike price + premium per share. With options, as with all investing, there are opportunity costs that come from an uncertain future. As the saying goes, “you pays your money and you takes your chances”.
Details to Keep in Mind
In addition to the three risks described above, there are four important details to remember about options.
First are trading costs. While my examples excluded commission costs, in reality investors should always remember to factor these into their reward/risk calculations before selling any options.
Trading costs vary by broker, ranging from $0.70 per contract with a $1 minimum at Interactive Brokers (IBKR), to $12.95 for the first 10 contracts, and $1.25 per contract beyond that at Options Xpress.
Remember that a good rule of thumb is that trading costs should be kept to a maximum of 1% to 2% of your investment. For example, the Nov 11 $32 Pfizer puts that pay a $0.38 premium will net you $38 per contract. So if you can only afford to buy 100 shares of Pfizer then the $1 minimum commission at Interactive Brokers comes to a commission of 2.63%. That means you want to sell at least two contracts to spread the cost over both and lower the commission to $1.4 / $76 =1.84%.
This brings up a second point, selling options for income generation is most profitable if you spread out the lowest possible commission over as many contracts as you are comfortable selling. Of course, because each contract represents 100 shares that means potentially obligating yourself to buy several hundred, or even thousands of shares, which requires massive amounts of capital.
Similarly, selling even a single covered call assumes you have at least 100 shares of a stock you are willing to sell. In the case of Johnson & Johnson even one covered call represents over $12,000 worth of shares.
And speaking of costs, let’s not forget taxes. All option income, even that generated by selling contracts with a duration over one year, is taxed as short-term capital gains. That means at your top marginal income tax rate.
And since this is a highly capital intensive strategy, best used in large portfolios, that might mean that the IRS will get as much as 39% + 3.8% (Obamacare investment income surcharge) = 42.8% of the premium.
Which is why income generating options strategies are best done in a tax sheltered account, such as an IRA. Of course since those have contribution limits, most people’s accounts are smaller, which might limit how many contracts they can write.
Two other things to note with options and taxes. If you are assigned shares by a written put, the option premium does indeed reduce your cost basis when it comes time to calculate taxable capital gain. And when considering writing covered calls don’t forget that having shares called away will induce a taxable event, assuming the effective sell price is above your cost basis.
One other point to keep in mind. Because of the factors that determine premium size, options are best written on high volatility stocks, preferably highly liquid blue chips. This is because utilities such as Southern Company (SO), or AT&T (T) have very low betas, meaning very low volatility. So their option premiums are generally too low to make it worth pursuing the strategies described in this article.
And since options markets are less liquid than the stock market, trying to write options for small, less well-known companies can mean running into problems having your limit order filled. And even if the order for a smaller stock is filled, the difference in the bid/ask price can result in a lower premium, one that’s not worth making the trade given the risks inherent with these financial tools.
Closing Thoughts on Put and Call Writing for Dividend Stocks
Please don’t misunderstand me. Options are merely one tool to help long-term dividend investors meet their financial goals. No one needs to use options to be successful, as a buy, hold, add on dips, and reinvest the dividends approach is more than enough to build exponential income and wealth over time (learn seven habits of highly effective dividend investors here).
That being said, if you understand the details and risks entailed by options, they can be a powerful tool. And when used in concert with high-quality dividend growth stocks, options can help you accumulate shares cheaper, as well as generate income in a sideways or slowly changing market.
So if you have the interest, time, and sufficient capital to manage the risks involved with these powerful financials tools, conservative, income generating option strategies may be something to consider using to increase the long-term returns and income generation of your diversified, long-term dividend portfolio.