For dividend income investors not familiar with options, here are some simple ideas you should consider for getting higher yields with little or no additional risk.
This article is intended purely to introduce some simple, conservative options strategies for both decreasing risk and increasing income. Dividend investors, who are often unfamiliar with options, can then decide if these are worth further investigation. Readers will need to do more homework before implementing these strategies, and stay tuned for follow-up articles.
A. Options Need Not Be Risky or Complex
Most dividend income investors tend to be risk averse and prefer the simplicity of buying and holding quality stocks with reliable yields. For most dividend investors, the very word “options” connotes high risk and complexity.
In fact, there are options strategies that are simple, and can increase your annual yield with little or no additional risk. The level of risk and complexity varies completely with how you use options. It's like comparing auto racing to conservative driving. Both can be called driving, however the risk and skill levels demanded by the two activities differ dramatically. The same goes for options trading.
Again, used properly, stock options can actually reduce risk and increase your income.
B. Why Dividend Investors Should Consider Options
How would you like to make an additional 5%-10% or more annual yield on stocks you already own, and plan on holding? It’s possible by selling Covered Call options, which are just rights to buy your stock.
Are there stocks you would love to buy if they drop to a certain lower price? Rather than simply placing a buy order at that price, you can sell a put option, which is a contract to buy someone’s shares if they sink to a certain price. Your put option buyer gets insurance against a price decline below that price. You get the stock you’d have bought anyway – at a further discount equal to the put option sale price.
For overall portfolio insurance against market declines, you can buy put options on a major index or surrogate of an index.
C. Basic Concepts
Here’s the basic vocabulary of stock options.
An option is short for an options contract, which is a formal agreement providing the right (but not the obligation) to buy or sell a fixed number of 100 shares of a given stock on or by a specific date called the expiration date at a specific price called the strike price. Note that options typically trade in units of 100 shares called contracts. Thus instead of selling options on 300 shares, you’d sell three contracts. So if you trade online, you’d enter ”3” not 300 in the Quantity or Amount field when placing your sell order, otherwise you’ll be selling options on 30,000 shares. Your trading platform will alert you if your portfolio isn’t large enough to cover that, but if it is, you could make an expensive mistake.
2. Two basic kinds of options:
A call option is a right to buy. Visualize calling someone over to give you the shares for which they have sold you the right to buy at a given strike price and by a given expiration date.
There are two kinds of call options. Covered calls are rights to buy stock that the seller already owns, so he is "covered" against the risk of needing to buy shares that have suddenly risen in price in order to fulfill his obligation to the buyer of the call option on the expiration date.
FYI, selling naked calls means selling calls on shares the seller does not currently own, and who risks being forced to buy shares that have unexpectedly risen in order to fulfill his obligation, just like any short seller. This strategy IS obviously more risky and beginners should avoid it.
A put option is the right to sell. Visualize your putting the shares into a buyer's hands.
3. The Price of an Option is Composed of Two Parts:
Intrinsic value: Is simply the REAL value of the option if exercised at a given moment. If a stock sells for $10/share, an option to buy the stock for $5/share (i.e. a call option with a $5 strike price) is worth about $5/share, or $500/contract, since the owner could exercise the option and save that amount.
Only options that are in-the-money have intrinsic value.
That is, a call option (right to buy or call in) has intrinsic value only to the extent that its strike price is BELOW the market price, because it gives the owner the right to buy the stock below market value.
A put option (right to sell or put into the put option seller’s hands) has intrinsic value to the extent that its strike price is ABOVE the stock price, because it allows the owner to sell the stock above market value.
Time value: The value of the time left to exercise the option. An option is a right for a specified time. The more time left on the option for the price go in the owner’s favor, the more time value and the higher the option price.
4. In General, Sell Options, Don’t Buy Options:
Thus time works in favor of option sellers, and against option buyers. An option buyer must not only be right about the direction of the market (hard enough), but the timing as well, because the option becomes worthless after the expiration date. Thus the time value portion of the option is always dropping.
Unless you’re buying puts (rights to sell) as insurance, option buying is a riskier strategy better suited to those with more trading skills and/or risk tolerance than the typical income oriented investor.
In general, conservative income investors stick to selling options, except for buying index puts as portfolio insurance
Sell covered calls to enhance yield on stocks you own.
Sell puts in order to buy stocks you would buy at the strike price anyway in order to get them for even less, thus enhancing yield AND reducing risk of loss with a lower cost basis.
Below we will provide a brief introduction or review of some of the most basic options strategies for enhancing yield, reducing risk, or both.
2. Selling Covered Calls
Did you know that it’s very possible to earn an extra 5%-10% annual yield (or more) on stocks you already own? You could do it by selling a call option (an option to buy from you) on those shares at a price that’s a bit higher than the current price. Because you already own the shares, this call option is called a covered call. In other words, you’re covered against the risk of needing to buy the shares at a price above your strike price.
If you plan on holding the shares, there is no additional risk, because you’ve already assumed the risk of stock ownership.
There are only two possible outcomes, both of which are better than simply holding your shares.
· If, on the expiration date of the call option, the stock price rises above the price you specified, the strike price, your stock gets called, or sold at the strike price. You’ve lost nothing except the potential gain above the strike price. Again, if you planned on holding the stock, you wouldn’t have gotten that anyway.
· If the stock is below the strike price at the expiration date, the covered call option expires. You keep the stock and the sale price or premium.
In either case, you pocket the extra cash from selling the covered call option.
Obviously, we want to sell covered calls at a strike price above our cost basis, so we still profit if the market price is above the strike price and the shares are called. Ideally we’d like to sell at a strike price above where we believe the price will rise by the expiration date, so that we can keep both the premium and the shares.
B. The Tricky Parts
Timing: The hard part is in the timing. The more the options are out-of-the-money, i.e. the more the strike price is above the market price, the lower the value and price of the option, since the buyer has a higher risk of the option expiring worthless.
So covered call sellers ideally try to sell calls at market peaks. Few are good at market timing.
Option Price Increments: Unlike stocks, options are not sold in penny increments, rather at increments of between $2.50 and $5.00 or more, depending on how high the stock price. Thus you can’t always trade options at prices that will cover your cost basis AND give you a decent return.
When you sell covered calls, you risk missing at least some of an unanticipated rise in the stock price. If your strike price was below your cost basis in the stock plus the cash from the option sale, you risk a loss either from selling the stock at a loss or buying back the call for more than you sold it.
3. Selling Put Options on Stocks You Want to Own
Is there a stock you’d like to buy once it gets down to a certain lower price? How would you like the chance to buy at that low price, with an additional discount? You could do it by selling a put option (option to sell to you) on that stock at that desired strike price.
There are two possible outcomes, both of which are better than simply putting in a buy order at the given price.
- If, on the expiration date of the put option, the stock price is at or below the specified strike price, you pay for the stock at the price you wanted, with an additional discount in the form of the premium you were paid up front when you sold the option.
- If on the expiration date of the put option the stock is above the strike price, the buyer does not sell to you. You got paid for providing insurance to the buyer of the put option against a price drop below the strike price.
Again, in either case, you keep the premium from the sale of the option.
B. The Tricky Parts
Obviously, we want to sell puts at a strike price at or near strong support, at what we consider bargain levels. Ideally we’d like to sell at a strike price below where we believe the price is likely to drop by the expiration date, so that we can keep both the premium and the shares.
As with selling covered calls, the tricky part is in the timing. The more the options are out-of-the-money, i.e. the more the strike price is below the market price, the lower the value and selling price of the option, since the buyer bears greater risk of the option expiring worthless.
So put sellers ideally try to sell at market bottoms. Few are good at market timing.
Option Price Increments: Unlike stocks, options are not sold in penny increments, rather at increments of between $2.50 and $5.00 or more, depending on how high the stock price. Thus you can’t always sell put options at strike prices that are low enough to want to buy the stock, AND to get a good premium on the sale of the put.
When you sell a put, you risk “catching a falling knife,” that is, being obligated to buy a stock after its price has plummeted, and you wind up taking a loss either from buying a stock well above its market value or buying back the option for more than you sold it.
4. Buying Put Options on Stock Indexes or Their Surrogates for Overall Portfolio Insurance
Even an introduction to this strategy requires its own article, since this strategy can get complicated. For now, know that you want to take a certain portion of your dividend yield and use it to buy put options on an index or surrogate for one. For example, if you own a general portfolio, puts on the S&P 500 index or SPYs would work. Those heavy in energy would seek to dedicate a portion of their dividends to buy puts on something tracking energy. The idea is to get some insurance without gutting your returns. More on this at a later time.
5. Options are Not Always Available
You may not be able to trade options on thinly traded and/or foreign shares, especially if you only trade on U.S. exchanges. Fortunately many of our recommendations do have options, including most of the more liquid foreign ones.
BP, plc (BP), CNOOC Ltd. (CEO), Enid SpA (E), Total Fina Elf (TOT), Veolia Environmental SA (VE), AT &T Inc (T), Verizon (VZ), Otelco (OTT), Windstream Corp (WIN), Buckeye Partners (BPL), El Paso Pipeline Partners (EPB), Enterprise Products Partners (EPD), Energy Transfer Partners (ETP), Kinder Morgan Energy Partners (KMP), Magellan Midstream Partners (MMP), Nustar Energy (NS), ONEOK Partners (OKS), Sunoco Logistics Partners (SXL), TEPPCO Partners (TPP), Tortoise Energy Infrastructure Partners (TYG), Alliance Resource Partners (ARLP), Natural Resource Partners (NRP), Penn Virginia Resources Partners (PVR), Terra Nitrogen Company, L.P. (TNH), StoneMor Partners (STON) Dominion Resources Inc. (D), Duke Energy Corp (DUK), Progress Energy (PGN), Southern Company (SO)
6. Sources for Further Study
If the above strategies sound intriguing, you'll need to do more homework. Here are a few free sources for getting started.
A. Free Online Resources
Any internet search using various combinations of terms as
- "stock options" AND (introduction OR guide OR beginner)
- "options" AND "investing
- "options strategies" AND stocks
will provide you with numerous well written, more detailed introductions to the topic. A few sites to browse for introductions to options and terminology can be found here, here and lastly, here, (for ordering the books mentioned below and further materials for implementing his strategies).
There are many. Here are a few suggestions that would be an excellent start for high dividend and others who invest in stocks for dividend income.
Show Me the Money: Covered Calls & Naked Puts for a Monthly Cash Income by Ron Groenke, Keller Publishing, 2004: (Order via www.rongroenke.com or other online sellers). I actually read an earlier version called Covered Calls and Naked Puts, this is an updated version.
This book is one of the most mercifully clear, jargon-free and concise introductions to simple options strategies for income, yet at the same time provides fairly detailed explanations of how to implement the strategies discussed. Written as the story of a retiree who reunites with his old college Finance Professor in a Florida retirement community, the author explains his techniques through dialogues between the two men. The story slows down the information flow a bit, but many will find the book far easier to read than a typical book on the topic.
Put Options by Jeffrey M. Cohen, McGraw Hill, 2003. The best book I’ve found on how to use puts for both income reduction and risk. Some new twists on using puts, very worthwhile specifically for conservative, risk averse income investors. Great ideas, clear and well explained.
Disclosure: I have positions in most of the above mentioned investments.