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Selling put options (deep in the money) is an alternative way of purchasing shares of a company. More specifically, when one sells deep-in-the-money puts, it is equivalent to owning the corresponding shares as long as the stock price does not exceed the strike price of the options on their expiration date. The strategy exhibits certain advantages and suits well the profile of most investors that are interested in high-dividend stocks. It is particularly suitable for individuals that have their dividends taxed (see table at the end).

The most important advantage is that the investor receives in full the time value of the options, which will be greater than the dividend if the strike price is properly selected. The strike price should be selected carefully so as to yield a high time value (higher than the dividend) and simultaneously be hard to reach for the stock within the lifetime of the option (preferably one year).

The probability of the stock advancing higher than the strike price is low because the stock price is "burdened" by the high dividend, which is subtracted from the stock price in every quarter. Moreover, most high-dividend stocks are low-growth stocks that distribute a great portion of their earnings to their shareholders and a smaller portion on their future growth (cash cows). Therefore, the capital gains of these stocks tend to be limited.

A very important advantage of the above strategy that is not as obvious is the excellent behavior of the options during bad periods. If the stock falls significantly, the time value of the option greatly decreases (towards zero) and hence the astute investor will immediately switch from options to shares. More specifically, the investor will close the puts, receiving most of the initial time value of the options, and will simultaneously purchase the corresponding number of shares. In this way, the investor will receive both the initial time value of the option and the dividend of the stock, which means that the investor will essentially receive an almost double dividend during a bad year.

Moreover, another advantage of the strategy is that the investor can achieve a low to medium level of leverage, which is impossible when purchasing shares via the traditional way. More specifically, as the sale of put options immediately raises the amount of cash of the investor, the investor will be allowed to hold more shares than one's net worth would permit as long as the investor holds a portfolio margin account. Although leverage is a two-edged sword, a low level of leverage is beneficial to the prudent investor, as it enables him/her to purchase a new stock without having to sell another stock first. Usually a minimum amount of $100,000 is required for this type of accounts.

After the review of the advantages of the strategy of selling puts, one should keep in mind that there is no such thing as a free meal. The risk of this strategy is that the stock may advance far higher than the strike price of the options and hence the investor may miss a significant portion of potential capital gains. However, as mentioned above, the high-dividend stocks are usually the low-growth cash cows, which typically move much more slowly than the market (they have beta lower than 1). Moreover, it is quite doubtful that these stocks would produce any value to their shareholders if they reached very high levels. Therefore, the risk of this strategy is limited.

Examples of suitable stocks for this strategy are: Exxon Mobil (NYSE:XOM), Chevron (NYSE:CVX), McDonald's (NYSE:MCD), Wal-Mart (NYSE:WMT), Philip Morris (NYSE:PM) and Procter & Gamble (NYSE:PG). There are also other companies, which exhibit high growth and thus hardly distribute any dividend, but are suitable for this method thanks to the great time value of their options, which essentially rewards an investor with a great dividend even though the company hardly distributes any. Examples of such companies are: Apple (NASDAQ:AAPL), Cognizant Technology Solutions (NASDAQ:CTSH), F5 Networks (NASDAQ:FFIV), DirectTV (NASDAQ:DTV) and Bed Bath & Beyond (NASDAQ:BBBY).

The table below shows the annual yield of the Jan-15 put options of these companies (the values are live for the purpose of accuracy). It is evident that the sale of puts greatly increases the annual yield realized, particularly when compared to the yield of taxed dividends.

Stock

Current price

Strike of puts

Annual Yield of Put Options (%)

Annual Dividend Yield

Annual Dividend Yield After Tax

XOM

99.13

130

3.0

2.5

1.8

CVX

119.00

140

4.0

3.3

2.3

MCD

95.13

115

3.5

3.4

2.4

WMT

77.65

95

2.5

2.4

1.7

PM

82.45

95

4.4

4.6

3.2

PG

80.30

95

3.9

3.0

2.1

AAPL

544.76

700

4.2

2.3

1.6

CTSH

99.24

120

4.6

0

0

FFIV

93.51

140

2.0

0

0

DTV

70.83

90

1.5

0

0

BBBY

67.33

90

1.0

0

0

Disclosure: I am long CVX, WMT, PM, . I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Selling Puts Of High-Dividend Stocks For Maximum Yield