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.
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.
[drizzle]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