A Strategy For Generating Income In A Down Market

 |  Includes: ABT, JNJ, MO, PG, PM, SO, VZ
by: Parsimony Investment Research

As an investor, it is getting harder and harder to put new money to work in the current market environment. The U.S. economy continues to have significant headwinds (e.g., high unemployment, European contagion, weak housing market, high debt levels, etc.) and signs are definitely pointing toward a pullback in the equity market.

If you are an income investor utilizing dividend stocks for income, you are in a precarious position. If the equity market experiences a significant downturn, all stocks will likely decline in price (even high quality dividend stocks), and there is a chance that your entire dividend yield could be wiped out by a falling stock price (over the short term).

Generating Income in a Down Market

We think that selling cash-secured puts on high-quality dividend stocks is a perfect strategy for a conservative income investor in a down market. It allows investors to generate income while mitigating downside price risk.

If you sell a put, you have an obligation to purchase the stock at a predetermined price (strike price) on or before the expiration date (if the buyer of the put option wants to sell you the stock). Clearly, the risk is that the stock drops significantly below the strike and you are forced to buy the stock at a price well above market.

Here are our two risk management rules of put selling:

  1. Only sell put options on stocks that you want to own at the price you want to own them - With a put selling income strategy (focused on out-of-the-money puts), you get paid to wait for the price you want on a stock. If the price never drops to your strike, you get to keep the premium (income) as a consolation prize. Your downside is owning the stock at the strike price (keep that in mind as you analyze the ideas below).
  2. Don't sell "naked" - Just because options offer you leverage, it doesn't mean that you have to use the leverage. We recommend securing your short put position with cash (i.e., don't sell on margin). If you aren't willing to risk the cash to back it up ... don't sell the put!

Great Put Selling Candidates

Below is a list of stocks that we feel are great put selling candidates. This list is by no means exhaustive (there are literally hundreds of decent candidates out there), but it should help you get a feel for what to look for in a put selling candidate. As discussed above, the downside to a put selling strategy is owning the stock at the strike price. So we focused on high quality, low beta stocks with high dividend yields that we would love to own at a cheaper price. As shown in the table below, these companies have an average beta of 0.49 and an average dividend yield of 4.1%.

(Click charts to expand)

Choosing the Right Strike

Choosing the right strike price in a put selling strategy, like any investment decision, comes down to risk and reward. The table below analyzes various strike prices (July 2012 expiration) for Verizon Communications (NYSE:VZ). You can see that as margin of safety decreases (risk increases), yield increases. Note: Yield is based on a cash-secured position.

Putting It All Together

Below are the specific put options that we would recommend selling on the candidates that we highlighted above. On average, premium yield is 3.3% with a margin of safety of 10.9%.

Click to enlarge

We feel that this strategy is a great way to generate income in a down market...especially since the downside is owning a great company at a great price!

Disclosure: I am long ABT, MO, VZ.