How to Buy Dividend Stocks Below the Market

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 |  Includes: COP, SCCO
by: Double Dividend Stocks

What would you say if someone told you that you could consistently buy certain dividend stocks below the market, get paid now to do it, earn more money than the stocks' dividends paid, and defer your taxes on this money for a year?

Sounds like a pretty good deal, right? Well, it is, with a couple caveats, which are often negligible.

We're talking about selling cash secured put options, a conservative strategy that may seem counter-intuitive at first, but can be quite a lucrative cash cow once you understand how it works.

Here are two examples, using dividend paying stocks from our High Dividend Stocks By Sectors Tables:

Selling "Out of the Money" Cash Secured Puts for Southern Copper (NYSE:SCCO):

1. Instead of buying SCCO outright, at $35.43, go to SCCO's options chain, and find the January 2012 option table.

Click to enlarge

Click to enlarge

(Source: Schwab Streetsmart)

SCCO was selling at $35.43, so I picked the $35.00 strike price, just under the stock's current price, i.e. "out of the money."

The current bid for the $35.00 Jan. 2012 put was $3.70, meaning that a put "buyer" is willing to pay you $370.00 for each Jan. 2012 SCCO $35.00 put that you sell.

This is a 10.57% yield for a 190-day term, or approx. 20.31% annualized:

(Note: We listed the $1.12 in dividends for comparison to the option dollar only. Put sellers don't receive dividends. However, in this case, the option dollar you would receive is over three times the dividend amount.)

You'll find more details on this and other put sales in our Cash Secured Puts Table.

Step-by-step trade details. (We'll only sell one put option, to keep it simple):

1. "Sell to open" one Jan. 2012 $35.00 put option for SCCO: (symbol SCCO 01/21/2012) This sale obligates you to buy, (have "put" to you), 100 shares of SCCO at $35.00 until the Jan. 21, 2012 expiration date, which may or may not happen. (More info below).

2. Your broker reserves/freezes $3,500.00 in your account: Each option contract corresponds to 100 shares of the underlying stock. Thus, 100 shares of SCCO at $35.00 equals $3,500.00.

3. Your broker credits your account for $370.00 within three days. (Schwab usually does this immediately.)

Possible Outcomes at the Jan. 2012 Expiration:

1. SCCO's stock price stays the same or rises: You don't end up having to buy the 100 SCCO shares. Your $370.00 profit is a 2012 short term capital gain, with taxes due by April 15, 2013.

2. SCCO's stock price falls by less than approx. $3.70, (i.e. it stays above $31.30, your breakeven price): Same result as No. 1; your $370.00 profit is taxable in 2013.

3. SCCO's stock price falls to or below $31.30, your breakeven price: You are assigned/sold 100 shares at $35.00, but your actual net price is $31.30 (the $35.00 strike price, minus the $3.70 option premium money you received).

There's an interesting tax break you get when this happens: You don't have to pay a short term capital gains tax on the $370.00 you received. Instead, the IRS says that you must use the $370.00 to lower your tax basis on the 100 shares you had to buy.

So, if you end up holding your 100 shares of SCCO longer than 12 months, (past Jan. 21 2013), your short term capital gain is then treated as a long term capital gain, whenever you sell. In other words, your taxes on the $370.00 are deferred until you sell the underlying 100 SCCO shares.

That's a pretty good tax deal - you get the use of the $370.00 now, but you don't have to pay taxes on it until April 2013, providing it expires or is assigned in 2012. This is one of the reasons why Warren Buffett has made some massive put sales out into the future. He gets paid the put premiums up front, gaining the use of the money now while simultaneously delaying paying taxes on it until the year after they expire.

Example 2: Selling "In the Money" Cash Secured Puts for ConocoPhillips (NYSE:COP):

You probably heard about the proposed breakup of ConocoPhillips into two divisions that was announced Thursday, which analysts are valuing north of $90/share.

If you want to get in on this action, but you don't want the risk of buying COP outright, take a look at this next trade.

COP was selling at $76.38. But if you want to be aggressive, you could sell the Jan. 2012 $80.00 puts, and still have a $71.70 breakeven, well below the current price:

Click to enlarge

Click to enlarge

(Source: Schwab Streetsmart)

Again, the put option premium outstrips the dividend, this time by over six times:

You'll find more details on this and other put sales in our Cash Secured Puts Table.

Notes:

1. Some traders feel that it's not worthwhile selling puts, because the put premiums you receive may be less than the upside price gains if a stock takes off. While this can be true, selling cash secured put options gives you the benefit of instant cash participation now, vs. possible future higher gains. So, you take your put premium cash now and re-deploy it elsewhere, rather than having all of the money tied up in buying the stock outright and waiting for dividends.

2. Other traders say that, if the stock goes down, you could have bought it for even less than your breakeven price from a put trade. Since nobody knows the future, you have to decide if you would like to get "paid to wait" by collecting a put premium now, or hope that the stock does decline to your desired entry point.

3. What to do if the stock declines past your breakeven: Unlike just buying a stock, the put selling strategy also allows you to "retreat" if the trade goes against you, by "buying to close" your sold puts, (closing out the position), and selling lower strike price puts, to recoup part or all of a loss. You can also sell further into the future, and get more money, since the time value normally is higher the further out into the future that you sell.

4. You can often sell for more than the put bid price being offered. In the SCCO example, put bidders were offering $3.70, and put sellers were asking $4.20. Try selling at somewhere in the middle, or at least above the bid price, if there's a wide spread. The relative amount of bidders and sellers also impacts the price you'll get - there were 526 put sellers, vs. only 218 put bidders, so the balance is in the bidders' favor in this example.

Disclaimer: This article isn't intended as individual or personal investment advice. Please do your own due diligence.

Disclosure: Note, I am not long the underlying shares of SCCO or COP, but I am short SCCO puts and short COP puts.