My favorite trade for low interest environments like those found today is dividend arbitrage. Dividend arbitrage is the process of buying fundamentally sound high yielding stocks and selling deep in the money covered calls. Selling deep in the money calls effectively doubles the amount of shares you can purchase, meaning 2x the dividends, without the use of leverage, and virtually eliminates your possibility for loss. In this post I will show you how you can implement dividend arbitrage on Verizon Wireless (VZ) common stock.
The first step of dividend arbitrage is identifying a fundamentally sound high yielding company. If the company is not fundamentally sound the company may cut or reduce its dividend and worst of all their stock may lose enough of its value that it will deteriorate your initial capital. I believe Verizon Wireless to be a fundamentally sound company for a variety of reasons. As more of Verizon's customers begin switching to more expensive data plans, their revenue along with their margins will increase, which is the formula for earnings growth. Cell phones have become a necessary in today's society, and are no longer a cyclical good. Even in the case of another economic downturn it is likely not to affect their wireless business. Additionally, Verizon's Fios internet, land line, and cable businesses are also growing while those business segments of their competitors are remaining stagnant or shrinking. Most important to the dividend arbitrage investor is the constancy and the growth rate of the company's dividend. Since the inception of their dividend, Verizon has never missed a payment and has steadily grown their yearly dividend from $1.00 at its inception in 1987 to the current $2.00. This bodes well for the dividend arbitrage investor as it proves that Verizon is likely to continue and grow their dividend payments.
The next step to dividend arbitrage is identifying which calls are be sold on the shares of the company they are interested in purchasing. In the case of VZ, I would suggest investors sell the Jan 14 strike $20 for a credit of $20. Selling these calls would allow you to effectively double your buying power if your order is set up as a covered stock order. Meaning for $2000 you will be able gain exposure to 100 shares of VZ rather than 50 shares in a traditional share purchase. This also means that at the time of option expiration, you will be required to sell 100 shares of Verizon at $20. Twenty dollars will likely be below the market price, but the price is irrelevant to the dividend arbitrage investor as selling the strike $20 calls allowed investors to collect 2X the dividends and hedge against the movements in share price.
Example: I have $2000. With my $2000 I buy 100 shares of VZ (market price of $40) and immediately sell strike $20 Jan 14 calls for $20 (most brokers call this type of trade covered stock). Over the next two years I collect about $4 in dividends. At the time of option expiration I am required to sell my 100 shares in VZ at $20 regardless of the current share price. As long as the market price of VZ on the expiry of Jan 14 call options is above $20, my initial capital of $2000 is returned in full plus I have kept $4 in dividends over the 2 year period. Effectively I have achieved a yield of 10% with very little risk (risk of VZ common stock going below $20 is very small). Although 10% may not sound abnormal or shocking, it is quite impressive when a two year government bond is yielding a minuscule 0.24%! To further boost returns one could achieve margin financing at 3% and place the same trade to earn a 17% rate of return.
Dividend arbitrage can be used with any high yielding stock, but may prove difficult to implement for small cap stocks. For dividend arbitrage to work successfully there needs to be demand for the calls that one is selling, which may be difficult in illiquid options markets. Other companies that I suggest for dividend arbitrage include: YPF SA (YPF), AT&T Inc. (T) , Pitney Bowes Inc. (PBI), Eli Lilly & Co. (LLY) , and Embraer SA ADR (ERJ).
Disclosure: I am long VZ.