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On June 14, 2011, we wrote a popular article titled "Income Without the Dividend: A Strategy for Generating Income in a Down Market," which highlighted a cash-secured put selling strategy for high-quality dividend stocks.

At the time, we were expecting a pullback in the market and we recommended that income investors tread with caution by implementing an option income strategy that would mitigate short-term downside price risk without sacrificing much income. We suggested this strategy as an alternative to buying more stock at peak levels (i.e., "buy & hold").

In essence, this put selling strategy is a "market timing" income strategy. Recall that the downside of this strategy is owning the stock at the strike price (less premiums received) if the buyer of the option exercises his/her right to sell you the stock. In other words, you would be buying a great company at a great price. If the option is not exercised, you get to keep the premium.

The purpose of this article is to compare the actual real-time results of the put selling strategy with a pure buy & hold strategy. Our analysis will highlight three main data points that all income investors should consider when implementing an investment strategy.

  1. Maximum Drawdown
  2. Total Return
  3. Total Income Yield

Note: The maximum drawdown ("MaxDD") measures the maximum reduction in your investment capital from peak to trough and we feel that it is one of the best metrics to compare the risk of various strategies. In general, you should expect a minimum total return equal to the MaxDD (i.e., if MaxDD is 10%, you should expect a total return of at least 10%...or a Calmar Ratio of at least 1.00).

Recap

Below are the specific recommendations that we made in the article. These option trades, which had a 7-month time frame, officially mature next week. On average, the 7-month premium yield was 4.7% with a margin of safety of 12.0%.

(Click charts to expand)

General Market Thesis

As expected, the equity market did in fact experience a meaningful pullback. As shown in the chart below, the S&P 500 (NYSEARCA:SPY) had a 20% drawdown from July to October.

While low beta dividend stocks tend to hold up relatively well in a downturn, typically no stock is immune to a general market decline of this magnitude.

Buy & Hold Strategy

Below is a breakdown of how the seven stocks performed under a pure buy & hold strategy.

The Buy & Hold analysis above assumes that each dividend stock was purchased on June 13, 2011 (the date the put selling strategy was implemented). The big winners on a buy & hold basis were Abbott Laboratories (NYSE:ABT), Altria (NYSE:MO), Philip Morris International (NYSE:PM), and Verizon (NYSE:VZ), while AT&T (NYSE:T), ConocoPhillips (NYSE:COP), and Proctor & Gamble (NYSE:PG) lagged. However, despite the general market pullback, the ensuing market rally generated a positive total return over the period for all seven stocks.

Average Holding Period Statistics for Buy & Hold Portfolio:

  • Income Yield: 3.14%
  • Total Return: 8.65%
  • MaxDD %: -9.66%
  • Calmar Ratio: 0.89

Put Selling / Market Timing Strategy

Below is a breakdown of how the seven stocks performed using the put selling strategy.

Of the seven stocks in the analysis, only one put option would have likely been exercised during the investment period, ConocoPhillips. While all the other stocks, spent less than three days below their respective strike prices during the period, ConocoPhilips closed below its strike price of $65.00 a total of 21 times. As such, we assumed that the COP option was exercised.

It's important to note here that any of the options could have been exercised during the period. However, other than COP, the probability of exercise for the other options was extremely low. In hindsight, given the subsequent rally in the stocks, an early exercise of any of the options would have been welcomed with open arms.

Average Holding Period Statistics for Put Selling Portfolio:

  • Income Yield: 3.95%
  • Total Return: 6.10%
  • MaxDD %: -0.04%
  • Calmar Ratio: 163.10

Conclusion

The most important takeaway from this analysis is that the put selling/market timing strategy subjected the investor to substantially less risk (as measured by the MaxDD) over the investment period.

While the buy & hold portfolio came out ahead from an absolute total return standpoint (8.7% vs 6.1% for the put selling portfolio), the difference in draw down cannot be ignored. The put selling portfolio essentially had a MaxDD of 0% (vs. a MaxDD of 9.7% for the buy & hold portfolio). From a risk-adjusted return standpoint, the put selling income strategy is clearly superior to the buy & hold strategy.

Most buy & hold strategies will typically have a calmar ratio below 1.00 since the investor will always experience the full draw down of the asset. Our view is that an investor should never subject himelf to this type of risk...especially when there are easy to implement, risk-reducing strategies like the one discussed in this article.

Buy & hold income investors will often argue that they "don't care about the day-to-day fluctuations in the stock price as long as the dividend checks keep rolling in." We think that this is a ridiculous mindset for any investor to follow. Why subject yourself to risk that you can easily mitigate?

Regardless, this argument is moot since the put selling portfolio actually had a higher income yield over the investment period (3.9% vs. 3.1% for the buy & hold strategy).

Let the Debate Begin...

While the results in this article should not be ignored, we realize that this was a small sample size and and a short investment period.

However, we strongly believe that a combination of market timing strategies (including this put selling strategy) would also produce superior risk-adjusted results over a much longer time frame as well.

All that said, timing the market is not easy and pure income investors should definitely hold a core portfolio of high-quality dividend stocks for stable income. But when putting new money to work, investors should take into consideration the general market environment and mitigate any downside risk when possible (especially if you can do so without sacrificing any income).

Pure dividend growth investors may disagree...but we hope this ignites a healthy debate on the subject.

Source: Income Strategy Debate: Buy And Hold Vs. Market Timing